A reader writes in, asking:
“With regard to selecting a ‘cost basis method’ for a brokerage account, Vanguard and others say that the specific identification method may allow for ‘greater tax efficiency’ than other methods. I get that the specific identification method lets me choose which shares to sell, so I have more control. But how should I actually decide which shares are the most tax efficient ones to sell?”
As a bit of background, selecting a cost basis method is important when investing in a taxable brokerage account, because it affects how your capital gains/losses are calculated whenever you sell shares of any of your holdings.
Example: You have a taxable brokerage account in which you own 1,000 shares of Vanguard Total Stock Market Index Fund, purchased over several years, at various prices. Now you place an order to sell 200 shares. For the purpose of reporting capital gain or loss on the sale, which 200 shares (out of the 1,000 that you own) will be sold? It depends on which cost basis method you are using.
The three options for cost basis method are:
- Specific identification, in which you tell the brokerage firm which specific shares you are selling;
- First-in-first-out, in which it is always assumed that you are selling your oldest shares of the holding in question; and
- Average cost, in which, for each holding, the total cost basis of all of your shares is added together, then divided by the number of shares you own, for the sake of calculating an average basis per share. And then each share is considered to have that average basis. (In other words, for a given holding, all of your shares are considered to be the same as each other.)
The specific ID method requires the most work, because you have to choose which shares to sell. In addition, you have to keep records of all of your purchases and sales in order to track the basis for each of the shares you own. (For shares purchased after 2011 the brokerage firm will track this for you, as long as you have told them you want to use the specific identification method. But it’s wise to keep records yourself as well.)
But the upside of the specific ID method is that whenever you sell shares, you can sell the shares that are most tax-efficient to sell at that time.
In most cases, that means selling the shares with the highest cost basis — with the reasoning being that doing so results in the smallest capital gain (and therefore the lowest tax cost) or the largest loss (and therefore the greatest tax savings).
However, there are two important exceptions.
First, if selling the shares with the highest cost basis would mean realizing a short-term capital gain (because you’ve held those shares for 1 year or less), then you might want to sell other shares instead. Short-term capital gains are taxed at ordinary income tax rates, whereas long-term capital gains are taxed at lower tax rates. So instead of selling your highest-basis shares, you might want to sell your highest-basis shares out of the shares that you’ve held for longer than one year.
Second, if your taxable income including capital gains is below (for 2018) $38,600 if single or $77,200 if married filing jointly, long-term capital gains have a 0% tax rate. So you may want to sell the shares with the lowest cost basis. That is, you may want to “harvest” the largest gain possible.
Hi. I'm Mike Piper, the author of this blog. I'm 
