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How Does Taxable Money Work? - Cost Basis Thumbnail

How Does Taxable Money Work? - Cost Basis

Elements of FP Investing

An Example of How Taxable Money Works - Cost Basis


Investments typically use one of three standard reporting methods for cost basis on sales of assets.


  1. FIFO - First in, First out - is an asset-management and valuation method in which assets acquired first are sold first 
  2. LIFO - Last In, First Out - is an asset-management and valuation method  in which the assets acquired last are sold first
  3. Average Cost - An asset-management and valuation method assigns a cost to inventory items based on the total cost of goods purchased in a period divided by the total number of items purchased. The average cost method is also known as the weighted-average method.


An Example of Cost Basis: (For illustration purposes only- not a real scenario) 

Share Purchases for all examples

             

ABC Company:

4/2/21 50 shares at $5 each

6/2/21 50 shares at $15 each

FIFO Example

             

You sell 50 shares at $20 on 6/3/22.

The shares you sold are the first purchases, (First In, First Out) 

$20 (Sale Price) - $5 (Cost Basis) = $15 per share capital gain, since this was sold after 1  full year, this would be Long-Term Capital gain and fall under Capital Gain tax rates. (If you would have sold within a year, it would be considered Short-Term and be taxed at your ordinary-income rate.


LIFO Example

             

You sell 50 shares at $20 on 6/3/22.

The shares you sold are the Second purchases, (Last In, First Out) 

$20 (Sale Price) - $15 (Cost Basis) = $5 per share capital gain, since this was sold after 1  full year, this would be Long-Term Capital gain and fall under Capital Gain tax rates. (If you would have sold within a year, it would be considered Short-Term and be taxed at your ordinary-income rate.

Average Cost Example

             

You sell 50 shares at $20 on 6/3/22.

The shares you sold are averaged out over the entire purchase: 50 x $5 + 50 x $15 = $1,000/ 100 shares = $10 average cost

$20 (Sale Price) - $10 (Cost Basis) = $10 per share capital gain, since this was sold after 1  full year, this would be Long-Term Capital gain and fall under Capital Gain tax rates. (If you would have sold within a year, it would be considered Short-Term and be taxed at your ordinary-income rate.


This illustration shows the importance of knowing how cost basis works on taxable investments. Keep in mind that most taxable situations are not as simple as the example outlines.

However, a misunderstanding can cause you a larger taxable event when that was not your intention. 


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