FIFO vs. Average Cost Method

Under federal tax law, you have to pay taxes on realized gains in the value of assets that you sell, including mutual funds, stocks and securities. The amount of tax that you pay depends on how you report you earnings. The first-in-first-out (FIFO), and the average-cost-basis are two different methods for calculating your tax burden. Choosing the tax computation method that best suits your situation could save you a significant amount of money in either the short term or the long term.

In order to determine your tax liability on an asset sale, you must first determine your cost basis. This represents your nontaxable return of premium. You only have to pay taxes on profits that you make by selling your assets. However, you only have a cost basis if you buy securities or other assets with your net earnings. Your 401k and individual retirement arrangements (IRAs) contain pretax money so you have no cost basis since you have to pay taxes on both your principal and earnings when you actually access your funds. Therefore, the FIFO and average-cost-method only apply to sales of assets that you bought with after-tax money.

If you make a single-share purchase, then all of those shares have the same cost basis because you paid the same price for every share. However, if you buy quantities of the same share or asset at different prices over the course of time, then you have a different cost basis for every set of the share or asset that you bought. When you sell some of the shares, unless you specify otherwise, the Internal Revenue Service assumes that the assets that you sell first are also the one's that you bought first. Assuming that asset prices rise over time, this means that you pay more taxes on selling these shares then you would if you were to sell your last bought shares first.

You can opt to report your asset sales using the average-cost-method, in which case you add up the total value of all of your shares and divide the total premium spent between the number of shares that you own. You then have the same cost basis for every share regardless of the actual purchase price. If you only sell some of your shares, then the IRS assumes that you sell the shares that you have held longest first.

The IRS taxes long-term gains and short-term gains differently, and you can apply the average-cost-method to both your long-term and short-term capital gains. You pay ordinary income tax on profits garnered from assets that you hold for less than 12 months and the IRS calls these gains short-term capital gains. You pay the long-term capital gains tax on profits generated by selling assets that you held for more than 12 months. Therefore, you can apply the average-cost-method to both your long-term and short-term gains, and the IRS refers to this tax reporting method as the average-cost-double-category.