As you find ways to invest your savings for your family's future—whether it's through stocks, property or life insurance—the concept of cost basis likely will come into play. It's how much you originally paid for an asset, and it can help you understand how much you've gained or lost. This figure also could affect your tax bill, depending on your gains, losses or if you plan to sell the asset.
In this article, we'll cover:
What is cost basis?
Cost basis often is described as the original price you paid for an asset. That's a good starting point, but it's not the only factor in the equation. For example, commissions, reinvested dividends and transaction costs typically increase your cost basis, while depreciation of your asset reduces it.
What is cost basis in investments?
For example, when you purchase a
If you plan to sell your asset, cost basis could directly impact your tax liability. When it comes time to investigate the
So, if you have a share of stock or a mutual fund worth $50 and the cost basis is $20, then your gain is $30. If you sell that share, then you'll owe taxes on just that $30.
How to calculate an investment’s tax liability using cost basis
To determine your gains or losses, subtract your cost basis from your investment's current value. For example, if you have an investment now worth $25,000 with a cost basis (original price) of $15,000, then you have $10,000 worth of gains. If that same investment is only worth $10,000 now, then you have a $5,000 loss.
Calculating your cost basis can be more complex if you've accumulated shares at different times for different prices. When the original value of your shares differs and it comes time to sell them, you should assess the 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.
These are your calculation options:
- Average cost. You can choose to add together the shares you've purchased, no matter when you purchased them. Then, you'd divide their value by your number of shares 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 can choose to first sell the shares that had the highest cost per share when you purchased them.
- Low cost. You can 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 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, you can group shares based on the amount of losses or gains they produced in the holding period (or how long you've owned them) when you go to redeem them.
Each of these methods has a different calculation formula. Here's an example of how to calculate cost basis for investments with the average cost method:
Say you have a $3,000 total cost basis of shares owned, and you 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)
Cost basis & long- vs. short-term gains
If you want to minimize your tax implications, it's important to keep holding periods in mind. How long you own shares can affect the tax rate you pay.
Short-term gains, which are gains on assets you've held for one year or less, are taxed as ordinary income. Gains on assets that you've held for longer than a year are considered long-term gains and are
As mentioned above, dividends reinvested into additional shares also have a cost basis and a holding period, so be sure to consider these factors as part of the decision on which shares to sell.
And remember, the less you spend on taxes, the more money you have available to support your personal and financial goals.
How capitals gains tax on investments works
What is cost basis in life insurance?
Life insurance proceeds are generally not taxable to beneficiaries when you pass. Additionally, distributions taken from the cash value during the insured's lifetime also may be received income-tax free. If you take a partial withdrawal of the cash value up to the amount of your cost basis, you typically won't incur a tax bill because distributions are treated on a first-in, first-out basis. The money you withdraw is assumed to come first from the cost basis and then taxable gains.1,2
The sum of premiums you've paid is the starting point for determining the cost basis of a life insurance contract. However, cost basis also is affected by things like:
- Prior withdrawals. These reduce your cost basis.
- Dividends. If you receive these dividends as a cash payment, then your cost basis is reduced. However,
using the dividends to purchase additional coverage typically does not affect your cost basis.
You also can borrow money from the cash value of your policy through a policy loan. Loans can be a helpful feature since it provides you with an additional source of liquidity without surrendering your policy or triggering a taxable event.3
Consider cost basis in your financial plan
Your cost basis is the amount of an investment or life insurance contract that you won't owe taxes on when you sell it or cash it out. But it often comes down to more than just the original price you paid. Certain factors can affect your final cost basis.
Understanding how cost basis works and how to calculate it for your specific situation can help you grasp how selling investments or cashing out a contract may impact your tax liability. A
