How cost basis works & can minimize tax implications

Investing can help you prepare for retirement and make the most of your hard-earned money. But there's no one right way to invest and no set results waiting for you at the other end. Investing can be a tricky business, but when it comes time to review investment performance, you can look at the cost basis of the shares you own to help get a clear idea of how much money you've gained or lost over time.

When it comes time to investigate the capital gains or losses on an investment, you need to determine the cost basis of it first. The cost basis determines how much of a gain or loss you have to report on your income tax return when you sell a share of a mutual fund. When you purchase a mutual fund share, you do so at a certain price. That price is the cost basis for that share.

The cost basis affects the taxes you pay (or don't pay) when you sell shares of a stock. Usually, the cost basis is only used when selling shares from taxable investing accounts; tax-deferred accounts for education or retirement savings aren't applicable here.

This is a very simple way to address what cost basis is, but things can get more complicated if you have long-term investments and bought shares by reinvesting dividends and capital gains. Making a new purchase through recurring or one-time investments also can complicate things. This is because mutual fund share prices ebb and flow. If you bought shares at varying moments in time, the cost basis for the shares (even if they're from the same mutual fund) can be different.

When the original value of your shares differs and it comes time to sell them, you should assess the different cost basis methods available to help decide which shares to sell first. The goal here is to choose which shares to sell strategically, so you can decrease your tax bill and have more money available to help reach your financial goals, such as having enough money saved to enjoy retirement.

Cost basis can help you make more strategic sale decisions, but it's also a legal requirement thanks to the Emergency Economic Stabilization Act. This act aims to improve compliance with tax laws and help fund the Troubled Assets Relief Program.

Under this act, any mutual shares purchased on or after January 1, 2012, require cost-basis information when it comes time to sell them. Equity securities and debt securities also are impacted.

You can calculate cost basis using quite a few methods. The different calculations look at the order in which your shares will be redeemed when you sell your investment and determine your capital gain or loss:

• Average cost. You can choose to add together the shares you've purchased, no matter when you purchased them, and then divide their value by the number of shares you have to determine the average cost basis per share. This can reveal how much you've gained or lost overall.
• First in, first out. With the FIFO method, the first assets you bought are the shares you sell first.
• Last in, first out. With the LIFO method, the last assets purchased are the first ones you sell.
• High cost. You also can choose to first sell the shares that had the highest cost per share when you purchased them.
• Low cost. You aim to first sell the shares that had the lowest cost per share when purchased.
• Specific lot identification. You can select individual purchase lots to use to get your desired total sale amount when it comes time to sell them.
• Loss/gain utilization. If your goal is to generate the least potential tax liability, when you go to deem the shares, you can group them based on the amount of losses or gains they produced in the holding period.

While these different methods have varying formulas to calculate cost basis, here's an example of how to calculate cost basis by using the average cost method: Say you have a $3,000 total cost basis of shares owned and own 100 shares. This is the formula you would use to get the average cost basis, which would result in $30 per share:

• $3,000 (total cost basis of shares owned) / 100 (total number of shares owned) = $30 (average cost per share)

If you want to minimize your tax implications, it's important to keep holding periods in mind. How long you own shares (also known as the holding period) can affect the tax rate you pay on capital gains. Long-term capital gains—or shares owned for more than one year—typically have the lowest tax rates while short-term gains on shares owned for one year or less adhere to the ordinary tax rate, which is higher. And remember, the less you spend on taxes, the more money you have available to support your personal and financial goals.

If you're unsure of what your next best move is, don't be afraid to ask for help. You can connect with a local financial advisor for additional guidance around cost basis and insight into how it can affect your retirement goals.