Re-investing dividends, and cost basis?

[spaghetti1awk]

Hi all- I am new to investing and have a question about re-investing dividends and a question about cost basis.

This is my first year investing in a taxable account (I also have a 403b and Roth IRA, and a 529). It's at Fidelity.

Over the last year I have been able to invest about 15000 in that taxable account (all in FZROX) across 4? different deposits. I understand that the cost basis is how much you paid for the (in this case) mutual fund, and that it's important to know what that was because when you sell, you'll pay capital gains tax on the difference between the sale price and the cost basis. This account currently shows the average cost basis, but apparently can also show the cost basis of each transaction. Here's my first question:

Why would I want to have Fidelity record the cost basis as average or as individual? What are the pros or cons to each?

My other question involves reinvesting dividends. I currently have the dividends set to reinvest, but I read somewhere that this might complicate an eventual tax situation? I suppose my question is two-fold. Is it wise to re-invest the dividends? (I thought so?) And two, if I do so, is this an argument for having fidelity track individual transaction cost basis rather than average?

I appreciate your crowd-sourced knowledge on this, and I apologize in advance if there is a thread answering this question that I was unable to find.

[Rob_bob]

Every time dividends are reinvested it is a new purchase starting a new clock on short term/long term tax holding period.  So you will have a mix of short and long term holdings.  This is more of an issue if you trade in and out of a holding rather than buy and hold long term.

Of course if you don't reinvest and just let the cash build for some period of time then invest it you will be doing the same thing but you can control the size of the tax lots and also be able to direct which investments you want to add to.  Many people use this as a way of rebalancing.

[MustacheAndaHalf]

The cost basis method is a better question for the taxes area.

Do they have other choices?  Vanguard offers "lot" (they prompt you to pick), FIFO (oldest sold first), HIFO (most expensive sold first).  I prefer "HIFO" to get the decision mostly right, and avoid the hassle.

I believe once you pick "average", you can only change it again after filing a form with the IRS and doing some bookkeeping.  I've avoided that, and so I avoid "average" cost basis.

[spaghetti1awk]

Thanks @Rob_bob and @MustacheAndaHalf for the insights. I hadn't even thought (despite using the word taxes in my original post) that this is basically a taxes question rather than strictly an investment one.

After digging more, it appears that Fidelity automatically(?) reports the IRA mutual funds as actual cost, but the 529 and taxable mutual funds as average cost, but all the accounts' "default disposal method" are FIFO. I'll continue the research about motivation for tracking actual rather than average, and have now scheduled a meeting with a friend who is also a CPA.

[MustacheAndaHalf]

FIFO is usually the least efficient choice, since the first shares you bought usually have the most gains.  So FIFO tends to trigger the highest taxes early.  The most efficient is "lot", meaning you pick each time.

Selling within 1 year incurs higher taxes than waiting 366 days, so that's a consideration.  If you pick the smallest gain from more than 1 year ago, that's generally optimal.  The less tax you pay now, the more you have to invest.

[spaghetti1awk]

FIFO is usually the least efficient choice, since the first shares you bought usually have the most gains.  So FIFO tends to trigger the highest taxes early.  The most efficient is "lot", meaning you pick each time.

Selling within 1 year incurs higher taxes than waiting 366 days, so that's a consideration.  If you pick the smallest gain from more than 1 year ago, that's generally optimal.  The less tax you pay now, the more you have to invest.

Thanks for the additional explanation. I think I'm starting to get it. Fidelity has a number of options for selling including an auto tax efficient strategy (that's at least how it is labeled). It looks like the first step is to change from average to actual cost basis because it seems there is in its current state no option to switch from FIFO.

[Proud Foot]

Using "lot" as the cost basis allows you to do more tax loss harvesting to offset any realized capital gains. Yes, even without selling any shares you will most likely have some capital gains from your mutual funds each year.

As @Rob_bob said, reinvesting dividends will give you a mix of short term and long term holdings. The biggest thing to look out for is not running afoul of any wash sale rules if you do try to tax loss harvest. This is important if you hold the same funds within your IRA and taxable accounts.

[phildonnia]

My other question involves reinvesting dividends. I currently have the dividends set to reinvest, but I read somewhere that this might complicate an eventual tax situation? I suppose my question is two-fold. Is it wise to re-invest the dividends? (I thought so?)

The question is, did you invest so you could have a steady stream of income, or so that you could amass wealth?  Dividend-paying stocks (and the mutual funds that invest in them) are usually aimed at investors that want income.  When you reinvest, you are basically saying: I don't want the money, I want more investment.  It's kind of like turning a dividend fund into a growth fund.  Whether that's you or not, is up to you to determine.  But if you're just getting started investing, it's likely that you don't want the money right now (or you wouldn't be sending any to the brokerage in the first place!)

And two, if I do so, is this an argument for having fidelity track individual transaction cost basis rather than average?

As you probably figured out, reinvested dividends are added to your cost.  When you sell (assuming average-cost), you are selling mostly from your initial investment, plus little bits from every reinvestment.  Additionally, some small percent of the shares sold will be short-term holdings, even if you've had the investment for ten years, and never seen any money.

"Complicated"?   Not really.  Fidelity will figure it all out for you, report your short-and long-term gains, and you just enter it into your tax software.  If you really want to, you can check their math, but I would trust that most large brokerages have worked all the bugs out of their software twenty years ago.  Using average-cost is probably the least complicated in terms of work for you.

[Holocene]

I'd avoid average cost basis.  You're better off deciding which lots to sell when the time comes so you can decide which lot best meets your needs.  If you're in a low tax bracket, you may want to sell shares that have appreciated a lot.  If you're in a higher bracket or want to try and keep your income under a certain amount (ie. for ACA subsidies) it may be better to sell shares that have less gains.  The average basis does not give you the same flexibility.  If you ever want to donate shares to a charity (either directly or through a Donor Advised Fund), it's also much more advantageous to be able to pick the most appreciated shares since you/the charity do not pay taxes on the gains and you can still deduct the full amount if you itemize.

Another thing to consider is that FZROX is probably not the best choice for a taxable account. 

First, mutual funds are generally not as tax efficient as ETFs.  Vanguard is the exception at the moment since they link many of their mutual funds to an ETF.  For example, I just converted VTSAX to VTI and kept the same cost basis.  They're basically equivalent, just different forms.  There's a patent for this that is expiring soon I believe, and other places may copy it.  But in general, mutual funds may incur more capital gains than ETFs each year, which you have to pay taxes on.  You can research this more, but there's a lot of info out there about how ETFs are more tax efficient than mutual funds.

Second, FZROX in particular is a mutual fund specific to Fidelity.  I don't believe you can hold it with any other brokerage.  So if for some reason, you decide you want to transfer to a different broker, you'd need to sell the FZROX and pay taxes on any gains.  For most other mutual funds and definitely ETFs, you can transfer in kind and keep your cost basis with the new broker.  I like Fidelity now too, but I like to keep my options open rather than be stuck with them.

FZROX is certainly not a terrible choice, but I'd recommend putting any new money into an ETF like VTI.  With another great year of gains, it's probably not worth selling the FZROX at this point.  I'd maybe try to reinvest dividends into the new ETF if you can rather than into FZROX.  But yes, you should reinvest dividends unless you need the money for something.  It's not really more complicated, it just adds more lots.  That's not really a bad thing, just more to keep track of, which Fidelity does for you.  For many years, I invested weekly into VTSAX at Vanguard, like $150-200 a week.  This means I have a ton of lots.  In hindsight, I probably could've just done once a month and avoided many of the extra lots and it wouldn't have changed things much.  I wanted to avoid buying at the worst time and justified spreading it out because of this.  It kept me investing which is the important thing.  So compared to my 52 lots per year, I wouldn't worry too much about 4 lots per year (assuming quarterly dividends)!

[spaghetti1awk]

Logging back in and realizing I neglected to thank you all for your help with this question. Thank you for helping me understand taxable accounts better!