Selling Index Funds & Cost Basis Method

[bigote2032]

Hello Mustachian friends, I hope you are all doing great/healthy in these crazy times.

I am still in the accumulating phase and have some doubts about selling index funds and the amount I would be taxes.  I am not too familiar with investing + tax implications so I will be grateful for some guidance, here are my questions:

1. I read somewhere the if you change the cost basis method, all the shares you bought to that point will be to be sold using the previous cost basis method.  If this is correct it will be pretty awful, all my funds are set to the default in Vanguard of "average cost" and I won't be able to use any other methods except for shares I buy after I do the change.

2. When I try to sell stock now (with average cost), Vanguard does not allow me to select the lots I want to sell (makes sense since they use average).  If I am not using average cost basis, would Vanguard user interface allow me to hand pick what lots I want to sell.  I think this will be the most accurate way to predict/calculate how much taxes I will owe for the stocks I am selling.  If you know how to calculate what is the capital gains of average cost of stocks I am selling that would be great to know.

3. I had in mind to sell the oldest shares first (the ones that should have the higher gains) but that will likely having me paying a higher amount of capital gain taxes.  What cost basis method do you recommend for somebody that when FIREd will only have income from his index fund dividends and capital gains?

Below is what I found in Vanguard regarding cost basis methods.

Thank you for your help!!

Vanguard offers the following cost basis methods for mutual funds: first in, first out (FIFO), highest in, first out (HIFO), specific identification (SpecID), and average cost (AvgCost). Learn more here.
Our default method for mutual funds is average cost. Our default for all other holdings is first in, first out.
If you use a method other than average cost for mutual funds, you'll need records for any shares acquired prior to January 1, 2012, because Vanguard only has average cost information available for these shares. Find out why.

[Grif]

I recently did something similar selling some VTSAX. I was able to switch my funds to specific Identification with no problem (I believe mine were set to average cost as well. I had never sold before and had never changed it.) I think they said it takes a while for the changes to go into effect so keep that in mind. And then you can choose exactly which shares to sell and at whatever basis they are. And when you are choosing the specific shares it calculates the basis and capital gains for you, and how much will be short term or long term based on that specific lot. I think SpecID gives the most flexibility for sure. It used to be more difficult before everything was digital, and if you didn't have the basis recorded for some assets then you were SOL. But now there's no question about having the basis and gains calculated digitally.

[MustacheAndaHalf]

You can change the cost basis method before you sell any shares - but I'm not sure about afterwards.  The "average cost" method blends all shares into one group, so that might not be something you can untangle easily (I forget... does it require filing a declaration with the IRS, and not being able to change it very often?)

I prefer "highest in first out" method, although it may pick suboptimal lots of you have a mix of long term and short term gains.  It's better than FIFO and more convenient than selecting lots, so I currently prefer it.

[bigote2032]

@Grif, thanks for your help.  I am going to change my VTSAX soon and wait a few days to see if it gives me the option to sell whatever lot of stocks I want.  That's great that gives you an estimate of the capital gains so you can plan for tax! :)  Thanks again!

[bigote2032]

@MustacheAndaHalf , thanks for your help! Some follow up questions,  so the "highest in first out" method  means that the stock lot that has the highest gains is sold first?

Yes, I am also curious on how many times we can switch the cost basis method, if there is a limit or no limit.  My main thing is being able to select the lots I want to sell so I avoid selling short-term stock and hand-pick to save as much as possible in tax.

Thanks again!

[G-dog]

@MustacheAndaHalf , thanks for your help! Some follow up questions,  so the "highest in first out" method  means that the stock lot that has the highest gains is sold first?

Yes, I am also curious on how many times we can switch the cost basis method, if there is a limit or no limit.  My main thing is being able to select the lots I want to sell so I avoid selling short-term stock and hand-pick to save as much as possible in tax.

Thanks again!

I was looking into this at the end of 2020.  The Vanguard default is average cost, but you can change that online.  I think if you select average cost, you may have to call them to reset that selection, and / or wait a set amount of time.  I don’t remember the details off of the top of my head, but do remember there is more info on their website. They also have short descriptions of the possible advantages and disadvantages of each cost basis method (which it disclaimed as not advice, just info).

[seattlecyclone]

You seem to want specific identification. This gives you the most control. If you're on specific identification you can mimic any of the other methods (by choosing the oldest shares, or the least appreciated shares, or spreading it across all your lots to get average cost, or something else entirely). The Vanguard online interface will show you the list of tax lots you have for that fund when you go to sell, and you'll need to specify how many shares are coming out of each lot.

No idea what they do about shares you bought before you changed your method.

[bigote2032]

@seattlecyclone Yes, that's it, I just selected specific identification in all my index fund in my brokerage account.  What's interesting is that for my IRA and ROTH IRA, it does not allow me to change the cost basis or it does not apply.  Weird.

I will try to sell in a few days to see what happens to my stock (if I am able to select specific lots or all the stock will forced to be sold using the cost basis method that I had set when I bought them (average).

Thanks for your help!

[bigote2032]

@seattlecyclone By the way, they passed capital gain tax in WA now, so I will have to be even more careful now when selling stock :(

[markbike528CBX]

@seattlecyclone By the way, they passed capital gain tax in WA now, so I will have to be even more careful now when selling stock :(. 

Do you have a link or reference?

[seattlecyclone]

@seattlecyclone Yes, that's it, I just selected specific identification in all my index fund in my brokerage account.  What's interesting is that for my IRA and ROTH IRA, it does not allow me to change the cost basis or it does not apply.  Weird.

There's no capital gains tax for IRA transactions, so the concept of cost basis isn't really important.

@seattlecyclone By the way, they passed capital gain tax in WA now, so I will have to be even more careful now when selling stock :(. 

Do you have a link or reference?

SB 5096. The proposal passed the state Senate, has not yet passed in the House. Click the "Engrossed Substitute" link for the full text of what passed in the Senate.

The bill exempts the first $250k of capital gains, plus all gains from the sale of real estate and all gains that occur within a retirement account.

If you have to take extra special care to avoid realizing over $250k of capital gains in a year, why haven't you retired yet? :-)

[bigote2032]

@seattlecyclone so this tax only applies for sell of stock with capital gains of $250K+ not sell of stock worth $250K+ (capital + gains)?

If the answer is yes then this is much more reasonable, I have not been able to find details of the bill in mainstream media and they were even mixing up this bill with Inslee's bill where the tax applied to sells of $25K for individuals and $50K for couples.

No, I unfortunately can't retire yet, probably 6 to 8 years from now, but selling of 25K of stock will take a hit with the other tax bill.

Thank you!

[bigote2032]

@seattlecyclone, thanks for the link, reading it now.

[markbike528CBX]

@seattlecyclone, thanks for the link, reading it now.

Yes, thanks.
I don't /won't have that much in capital gains. I'm safely under the 80,800 federal limit.  Nice to see what the hubbub is about.

[seattlecyclone]

@seattlecyclone so this tax only applies for sell of stock with capital gains of $250K+ not sell of stock worth $250K+ (capital + gains)?

Yes.

If the answer is yes then this is much more reasonable, I have not been able to find details of the bill in mainstream media and they were even mixing up this bill with Inslee's bill where the tax applied to sells of $25K for individuals and $50K for couples.

Looks like these were the amounts in the original version of the Senate bill. This was presumably too low for certain senators. They bumped the threshold up to $250k and that was enough to secure passage by one vote. We'll see what the House does.

[shuffler]

No idea what they do about shares you bought before you changed your method.

I will try to sell in a few days to see what happens to my stock (if I am able to select specific lots or all the stock will forced to be sold using the cost basis method that I had set when I bought them (average).

At Fidelity, the shares I had acquired under the average-cost method got that average-cost "baked in" as the cost-basis at the time I transitioned to specific-shares.  From then on, I could sell them individually, but they still retained the cost-basis that they'd had from back when they were averaged.

[bigote2032]

@seattlecyclone Got it, thank you and we will be watching the conclusion of this thing :)

[MustacheAndaHalf]

Some follow up questions,  so the "highest in first out" method  means that the stock lot that has the highest gains is sold first?

No, the opposite: the highest price is sold first, which has the least gains.  If the stock has been rising over time, that's typically the most recent purchases.

Yes, I am also curious on how many times we can switch the cost basis method, if there is a limit or no limit.

Before you sell, as many times as you want.  And I believe you can switch between lot selection, FIFO, and HIFO.  FIFO & HIFO simply decide the lot for you.  But I believe "average cost" might be different, but I've avoided it, so I don't know.

[bigote2032]

@MustacheAndaHalf thanks you for the information :)

[Reynold]

Regarding the average cost basis method, my understanding is that if you sell any shares using that method, the IRS won't let you undo it later. 

So if for example you buy 1000 shares of XYZ at $1/share, and later another 1000 shares of XYZ at $4/share, you have 2000 shares that cost a total of, i.e. have a total cost basis of, $5000. 

Say a month later it hasn't moved, and you sell 30 shares using the averaged basis method, you get 30 x $4/share = $120 dollars.  The average cost basis for your shares was ($5000 shares / 2000 shares) = $2.50 per share, so 30 shares times $2.50 gives $75, and you owe taxes on ($120 - $75) = $45 dollars in ill gotten gains, you capitalist. 

If you then go into your account and switch back to specific lots instead of averaging, I believe it will set the cost basis of all 1970 shares you still own at $2.50, you can no longer "go backward" and say I really meant to sell the 30 shares from the $1 lot or $4 lot, they have been cross mingled in the eyes of the IRS.  If you bought some new shares and didn't switch to averaging them, you could probably sell specific lots going forward, but that group of 1970 shares of XYZ is stuck at $2.50. 

If when you sold those $30 shares using the specific lots method, you could have had a zero or a substantially higher capital gains, depending on which lot you sold from.  You can see that gives flexibility when you have high income (i.e. working) or low (presumably retired).