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American Opportunity Tax Credit (AOTC): Definition and Benefits

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American Opportunity Tax Credit (AOTC): Definition and Benefits

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What Is the American Opportunity Tax Credit (AOTC)?

The American Opportunity Tax Credit (AOTC) is a tax credit for qualified education expenses associated with the first four years of a student’s postsecondary education. The maximum annual credit is $2,500 per eligible student. The student, someone claiming the student as a dependent, or a spouse making postsecondary education payments can claim the AOTC on their tax return.

Key Takeaways

  • The American Opportunity Tax Credit (AOTC) helps offset the costs of postsecondary education for students or their parents (if the student is a dependent).
  • The AOTC allows an annual $2,500 tax credit for qualified tuition expenses, school fees, and course materials.
  • Room and board, medical costs, transportation, and insurance do not qualify, nor do qualified expenses paid for with 529 plan funds.
  • To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 if married filing jointly).

Understanding the American Opportunity Tax Credit (AOTC)

With the AOTC, a household with a qualifying student can receive a maximum $2,500 tax credit per year for the first four years of higher education. Parents claiming a dependent child who is a full-time student ages 19 to 24 can claim an additional $500 Child Tax Credit.

The AOTC helps with educational costs such as tuition and other expenses related to a student’s coursework. Eligible students (or their parents) can claim 100% of the first $2,000 spent on school expenses and 25% of the next $2,000. This comes out to a maximum credit of $2,500: (100% × $2,000) + (25% × $2,000).

The American Opportunity Tax Credit is partially refundable, which means that it could provide a refund even if your tax liability is $0.

In general, tax credits are refundable, nonrefundable, or partially refundable. Up to $1,000 (40%) of the AOTC is refundable, making it a partially refundable tax credit. So, if the credit brings your tax liability to $0, you can receive 40% of your eligible credit (up to $1,000) as a refund.

AOTC Eligibility Requirements

Like other tax credits, you must meet specific eligibility requirements to claim the AOTC.

Who Can Claim the AOTC?

To claim the AOTC on your tax return, you must meet all three of these requirements:

  • You pay qualified education expenses for higher education.
  • You pay the education expenses for an eligible student.
  • The eligible student is either you, your spouse, or a dependent whom you claim on your tax return.

Additionally, you must receive Internal Revenue Service (IRS) Form 1098-T to claim the credit. Here’s an example of a completed form:

Source: Internal Revenue Service

Which Students Qualify for the AOTC?

A student is eligible for the AOTC only if they meet certain requirements. Specifically, the student must:

  • Be taking courses toward a degree or some other recognized education qualification
  • Be enrolled at least part time for at least one academic period beginning in the tax year
  • Not have finished the first four years of higher education at the beginning of the tax year
  • Not have claimed the AOTC (or the former Hope credit) for more than four tax years
  • Not have a felony drug conviction at the end of the tax year

Academic periods can be quarters, trimesters, semesters, or summer school sessions. If the school doesn’t have academic terms, you can treat the payment period as an academic period.

Which Expenses Qualify for the AOTC?

For the purposes of the AOTC, qualified education expenses include tuition and some related costs required for attending an eligible educational institution. An eligible educational institution is any accredited public, nonprofit, or private college, university, vocational school, or other postsecondary educational institution. Related expenses include:

  • Student activity fees paid to the school as a condition of enrollment or attendance
  • Books, supplies, and equipment needed for classes, whether or not you buy them from the school

Insurance, medical expenses (including student health fees), room and board, transportation, and living expenses do not count as qualified education expenses.

You can pay for qualified education expenses with student loans. However, you can’t claim the credit if you paid for expenses with scholarships, grants, employer-provided assistance, or funds from a 529 savings plan.

What Are the Income Limits for the AOTC?

To claim the full credit, your modified adjusted gross income (MAGI) must be $80,000 or less ($160,000 if married filing jointly). The credit begins to phase out above these limits and disappears entirely if your MAGI is above $90,000 ($180,000 for married filing jointly).

Income Limits for the American Opportunity Tax Credit
  Single Married Filing Jointly
Full Credit $80,000 or less $160,000 or less
Partial Credit More than $80,000 but less than $90,000 More than $160,000 but less than $180,000
No Credit More than $90,000 More than $180,000
Source: Internal Revenue Service

AOTC vs. Lifetime Learning Credit

The AOTC and the Lifetime Learning Credit (LLC) are popular tax breaks that people with educational expenses can claim on their annual tax returns. While similar, the LLC and the AOTC differ in several ways.

With the LLC, you can claim up to 20% of the first $10,000 of qualifying expenses ($2,000). The LLC is not limited to students pursuing a degree or studying at least part time. Instead, it covers a broader group of students—including part-time, full-time, undergraduate, graduate, and courses for skill development. Finally, the LLC is nonrefundable, meaning that once your tax bill hits zero, you won’t receive a refund on any credit balance.

American Opportunity Tax Credit (AOTC) vs. Lifetime Learning Credit (LLC)
 Criteria AOTC LLC
Maximum Benefit Up to $2,500 per student Up to $2,000 per return
Credit Type Partially refundable (40% of credit) Nonrefundable
MAGI Limit (Single) $90,000 $80,000
MAGI Limit (Married Filing Jointly) $180,000 $160,000
# of Tax Years Available Four per student Unlimited
Program Requirement Degree seeking N/A
Course Load At least half time for at least one academic period At least one course
Qualified Expenses Tuition, required fees, and course materials Tuition and fees
Felony Drug Conviction Not allowed N/A
Source: Internal Revenue Service

If you’re eligible for both the AOTC and the LLC, be sure to assess your individual situation to determine which tax credit provides the greater benefit. The partial refundability of the AOTC can be an important factor. Of course, some taxpayers may only qualify for the LLC, making the decision easy.

You can claim the AOTC and the LLC (as well as the deduction for tuition and fees) on the same tax return—but not for the same student or the same qualified expenses.

Other Tax Breaks for Education

Federal and state governments support higher education expenses through various tax credits, tax deductions, and tax-advantaged savings plans. Each of these programs can help lower your income tax liability and make education more affordable. Beyond the AOTC and the LLC, be sure to claim any education-related tax deductions for which you may be eligible, including those for:

Savings plans can also help with higher education expenses. These are tax-advantaged accounts that allow you to save—and pay for—education expenses. Two popular programs include:

Thanks to the Tax Cuts and Jobs Act, you can now use up to $10,000 of 529 plan distributions to pay for K–12 costs per beneficiary each year. Previously, you could use the funds only for college and other postsecondary education expenses.

AOTC Example

Rosa is a full-time undergraduate college student at a four-year institution. She also works for a law firm. Her parents have a substantial 529 savings account in place, but it doesn’t cover all of Rosa’s expenses. Rosa also has a student loan with deferred payments and interest until after graduation.

Rosa and her family pay her tuition with student loans and use funds from a 529 plan to cover room and board. Rosa receives her annual 1098-T statement and, since she is working, she plans to take the AOTC herself. She is eligible for both the AOTC and the LLC, but she chooses the AOTC because it provides a larger credit and is partially refundable.

Rosa paid her tuition with a student loan, which is allowable for the AOTC. The AOTC helps alleviate any tax that she owes and she also gets a partial refund. Rosa doesn’t owe anything on her loans until after she graduates. The money distributed from the 529 was tax-free because it was used for room and board, which is a qualified 529 expense.

How Do I Claim the American Opportunity Tax Credit (AOTC)?

To claim the American Opportunity Tax Credit (AOTC), complete Form 8863 and submit it with your Form 1040 or 1040-SR when filing your annual income tax return. Enter the nonrefundable part of the credit on Schedule 3 of your 1040 or 1040-SR, line 3. The refundable portion of the credit goes on line 29 of the 1040 or 1040-SR.

Can I Claim the AOTC and the Lifetime Learning Credit?

Yes. You can claim the AOTC and the Lifetime Learning Credit (LLC) on the same tax return. However, you can’t claim both credits for the same student or the same expenses during a single tax year.

Can I Claim the AOTC if I Get a Grant?

Yes. However, you need to subtract that amount from your qualified education expenses before claiming the tax credit. So, if you have $5,000 in costs and a $4,000 grant, you would be able to claim $1,000 of qualified education expenses for the AOTC. For the purposes of the AOTC, grants include:

  • Tax-free parts of scholarships and fellowships
  • Pell Grants and other need-based education grants
  • Employer-provided assistance
  • Veterans’ educational assistance
  • Any other tax-free payments that you receive for educational aid (excluding gifts and inheritances)

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Actuarial Science: What Is Actuarial Science? Definition and Examples of Application

Written by admin. Posted in A, Financial Terms Dictionary

What Is Actuarial Science? Definition and Examples of Application

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What Is Actuarial Science?

Actuarial science is a discipline that assesses financial risks in the insurance and finance fields, using mathematical and statistical methods. Actuarial science applies the mathematics of probability and statistics to define, analyze, and solve the financial implications of uncertain future events. Traditional actuarial science largely revolves around the analysis of mortality and the production of life tables, and the application of compound interest.

Key Takeaways

  • Actuarial science assesses financial risks in the insurance and finance fields, using mathematical and statistical methods.
  • Actuarial science applies probability analysis and statistics to define, analyze, and solve the financial impact of uncertain future events.
  • Actuarial science helps insurance companies forecast the probability of an event occurring to determine the funds needed to pay claims.
  • The Casualty Actuarial Society (CAS) and Society of Actuaries (SOA) promote several professional certifications for actuaries to pursue beyond a bachelor’s degree in actuarial science.
  • The most recent salary information from the Bureau of Labor Statistics shows actuaries earned an average salary of nearly $106,000 as of May 2021.

Understanding Actuarial Science

Actuarial science attempts to quantify the risk of an event occurring using probability analysis so that its financial impact can be determined. Actuarial science is typically used in the insurance industry by actuaries. Actuaries analyze mathematical models to predict or forecast the reasonableness of an event occurring so that an insurance company can allocate funds to pay out any claims that might result from the event. For example, studying mortality rates of individuals of a certain age would help insurance companies understand the likelihood or timeframe of paying out a life insurance policy.

Actuarial science became a formal mathematical discipline in the late 17th century with the increased demand for long-term insurance coverage. Actuarial science spans several interrelated subjects, including mathematics, probability theory, statistics, finance, economics, and computer science. Historically, actuarial science used deterministic models in the construction of tables and premiums. In the last 30 years, science has undergone revolutionary changes due to the proliferation of high-speed computers and the union of stochastic actuarial models with modern financial theory.

Applications of Actuarial Science

Life insurance and pension plans are the two main applications of actuarial science. However, actuarial science is also applied in the study of financial organizations to analyze their liabilities and improve financial decision-making. Actuaries employ this specialty science to evaluate the financial, economic, and other business applications of future events.

Insurance

In traditional life insurance, actuarial science focuses on the analysis of mortality, the production of life tables, and the application of compound interest, which is the accumulated interest from previous periods plus the interest on the principal investment. As a result, actuarial science can help develop policies for financial products such as annuities, which are investments that pay a fixed income stream. Actuarial science is also used to determine the various financial outcomes for investable assets held by non-profit corporations as a result of endowments. 

In health insurance, including employer-provided plans and social insurance, actuarial science includes analyzing rates of

  • Disability in the population or the risk of a certain group of people becoming disabled
  • Morbidity or the frequency and the extent to which a disease occurs in a population
  • Mortality or mortality rate, which measures the number of deaths in a population that result from a specific disease or event
  • Fertility or fertility rate, which measures the number of children born

For example, disability rates are determined for veterans that may have been wounded in the line of duty. Certain percentages are assigned to the extent of the disability to determine the payout from disability insurance.

Actuarial science is also applied to property, casualty, liability, and general insurance–instances in which coverage is generally provided on a renewable period, (such as yearly). Coverage can be canceled at the end of the period by either party.

Pensions

In the pension industry, actuarial science compares the costs of alternative strategies with regard to the design, funding, accounting, administration, and maintenance or redesign of pension plans. A pension plan is a defined-benefit plan, which is a type of retirement plan involving contributions from the employer to be set aside and paid out to the employees upon retirement.

Short-term and long-term bond rates greatly influence pension plans and their investment strategies. Bonds are debt instruments issued by governments and corporations that typically pay a periodic interest rate. For example, in a low-interest-rate environment, a pension plan might have difficulty earning income from the bonds that it has invested in, which increases the probability that the pension plan could run out of money.

Other factors impacting a pension plan’s viability include benefit arrangements, collective bargaining, the employer’s competitors, and changing demographics of the workforce. Tax laws and the policies of the Internal Revenue Service (IRS) regarding the calculation of pension surpluses also impact the finances of a pension plan. Additionally, economic conditions and trends in the financial markets can impact the probability of a pension plan remaining funded.

Actuaries may also work in the public sector to assist with proposed changes to Social Security, Medicare, or other programs.

Universities and Professional Certifications

According to the Bureau of Labor Statistics, the number of actuaries employed is expected to grow 21% from 2021 to 2031. For this reason, many universities offer educational degrees and courses on actuarial science. In addition, there are professional designations for those interested in pursuing the field.

Universities

The Society of Actuaries identifies and reports colleges that meet one of three levels of recognition:

  • UCAP-Introduction Curriculum: Universities that maintain course requirements for two professional actuarial exams in addition to having met other approved course requirements.
  • UCAP-Advanced Curriculum: Universities that maintain course requirements for four professional exams in addition to having met other approved course requirements.
  • Center of Actuarial Excellence: Universities that maintain eight specific requirements in connection with a variety of matters. This is the highest tier of competency identified by the SOA for a university.

As of December 2022, there are roughly 25 Center of Actuarial Excellence schools across the United States, Canda, Australia, Singapore, the United Kingdom, and China. Within the U.S., these schools include but are not limited to Brigham Young, Georgia State, Purdue, Connecticut, and Michigan.

Compensation

According to the latest BLS wage data, the median annual wage for actuaries in 2021 was $105,900.

Professional Designations and Credentials

There are a number of different professional designations an actuary can pursue to further gain credibility and proficiency in their field. The Casualty Actuarial Society offers the Associate (ACAS) and Fellow (FCAS) membership levels, each of the two with escalating requirements. For example, the ACAS credential can be achieved after passing six exams, while the FCAS is earned after nine exams. Areas of focus for the FCAS exam include:

  • Probability
  • Financial Mathematics
  • Financial Economics
  • Modern Actuarial Statistics
  • Basic Techniques for Ratemaking and Estimating Claim Liabilities
  • Regulation & Financial Reporting
  • Policy Liabilities, Insurance Company Valuation, and Enterprise Risk Management
  • Advanced Ratemaking

The Society of Actuaries promotes several different actuarial exams to demonstrate competency in the field.

  • An Associate of the Society of Actuaries (ASA) demonstrates knowledge of fundamental concepts of modeling and managing risk. The examination requirements are changing as of Spring 2023, and the list of required examinations includes topics on predictive analysis, economics, probabilities, and financial markets.
  • A Chartered Enterprise Risk Analyst (CERA) specializes in having knowledge in identifying, measuring, and managing risk in risk-bearing enterprises. Similar to the ASA requirements, the CERA requirements include a professional course covering code of conduct.
  • A Fellow of the Society of Actuaries (FSA) demonstrates knowledge of financial decisions involving pensions, life insurance, health insurance, and investments. FSAs also must demonstrate in-depth knowledge and the application of appropriate techniques to these various areas.

Is Actuarial Science Difficult?

Actuarial science is a difficult profession. Actuarial exams usually last between 3 and 5 hours, and each requires rigorous preparation. Candidates must often have a bachelor’s degree, and it make take up to a decade for a candidate to complete all training and exams.

What Type of Math Do Actuaries Use?

Actuaries often have a background in probability, statistics, and financial mathematics. Most often, an actuary will assess the probability of an event happen, then apply statistical methods to determine what the financial impact of that outcome will be. Actuaries usually do not use calculus at work, though calculus may be a prerequisite to meeting other course requirements.

How Long Does It Take To Become an Actuary?

For most, it may take up to a decade or longer to become an actuary. A bachelor’s degree in actuarial science may take between 3 to 5 years, and it may take at least another several years to pass rigorous professional actuarial exams.

The Bottom Line

Actuarial science is the study of mathematically predicting the probability of something happening in the future and assigning that outcome a financial value. Companies, pension funds, and insurance agencies rely on actuaries to develop models to assess areas of risk and devise policies to mitigate potential future challenges.

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Adjustable Life Insurance: Definition, Pros & Cons, Vs. Universal

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Adjustable Life Insurance: Definition, Pros & Cons, Vs. Universal

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What Is Adjustable Life Insurance?

Adjustable life insurance is a hybrid of term life and whole life insurance that allows policyholders the option to adjust policy features, including the period of protection, face amount, premiums, and length of the premium payment period.

Adjustable life policies also incorporate an interest-bearing savings component, known as a “cash value” account.

Key Takeaways

  • Adjustable life insurance allows policyholders to make changes to their cash value, premiums, and death benefits.
  • It gives policyholders the ability to reformulate their insurance plans based on shifting life events.
  • There is a savings component, known as a “cash value” account, with adjustable life insurance.
  • When the cash value in an adjustable life insurance policy grows, the policyholder may borrow from it or use it to pay their premiums.
  • The cash value earns interest often at a guaranteed rate, but the interest gains are usually modest.

Understanding Adjustable Life Insurance

Adjustable life insurance differs from other life insurance products in that there is no requirement to cancel or purchase additional policies as the insured’s circumstances change. It is attractive to those who want the protection and cash value benefits of permanent life insurance yet need or want some flexibility with policy features.

Using the ability to modify premium payments and face amounts, policyholders may customize their coverage as their lives change. For example, a policyholder may want to increase the face amount upon getting married and having children. An unemployed person may want to reduce premiums to accommodate a restricted budget.

As with other permanent life insurance, adjustable life insurance has a savings component that earns cash value interest, usually at a guaranteed rate. Policyholders are permitted to make changes to critical features of their policy within limits. They may increase or decrease the premium, increase or decrease the face amount, extend or shorten the guaranteed protection period, and extend or shorten the premium payment period.

Adjustments to the policy will alter the guaranteed period of the interest rate, and changes in the length of the guarantee will change the cash value schedule. Decreasing the face amount is done upon request or in writing. However, increasing the face amount may require additional underwriting, with substantial increases requiring full medical underwriting.

Increasing the amount of the death benefit could require additional underwriting, and substantial increases may call for full medical underwriting, which would mean an updated medical exam.

Factors That Can Be Adjusted

Three factors can be changed in an adjustable life insurance policy. These are the premium, cash value, and death benefit. All three elements can be adjusted because this policy is a permanent life insurance policy and does not expire, like a term life policy.

Premiums can be changed by frequency or amount of payments, as long as you pay above the minimum cost. The policy’s cash value can be increased by upping your premium payments. You can decrease your cash amount if you withdraw funds or use the cash in the policy to pay the premiums.

Finally, you can adjust your death benefit by decreasing or adding to the amount. If you decide to add a significant amount to the death benefit due to a life event like the birth of a child, your premiums may go up based on the new benefit amount. In some cases, your policy will have to undergo additional underwriting.

Advantages and Disadvantages of Adjustable Life Insurance

Adjustable life insurance gives policyholders more flexibility than term life insurance, but it is more expensive than a simple 20- or 30-year term policy. If you plan on using adjustable life insurance as an investment vehicle, you may be better off with a tool that earns more interest. Adjustable life insurance only provides modest amounts of interest growth.

Pros

  • Cash value grows over time

  • You can decrease or increase your death benefit

  • The most flexible of all types of life insurance

Cons

  • Is expensive to purchase

  • Interest earnings may be modest

  • If you largely increase your death benefit, your premiums may rise

Guidelines for Life Insurance Policies and Riders

Internal Revenue Code (IRC) Section 7702 defines the characteristics of and guidelines for life insurance policies. Subsection C of this section provides guidelines for premium payments. The policyholder may not adjust the premiums in a manner that violates these guidelines. Increasing premiums may also increase the face amount to the point that it requires evidence of insurability.

However, many life insurers set parameters to prevent violations. Adjustable life insurance policies typically have optional riders. Familiar ones include the waiver of premium and accidental death and dismemberment riders.

What Is the Difference Between Adjustable Life Insurance and Universal Life Insurance?

Adjustable life insurance is another name for universal life insurance. There is no difference between them, because they are the same type of policy.

What Does an Adjustable Life Policy Allow a Policy Owner to Do?

An adjustable life policy allows a policy owner to make changes to the death benefit amount, adjust their payment on their premiums, and add money or remove money from their cash value.

What Is Credit Life Insurance?

Credit life insurance may be offered when you take out a large loan, such as a mortgage. This type of life insurance is used to pay the loan off if the borrower dies before the loan is repaid. For example, if you co-sign a 30-year mortgage with your spouse, and your spouse dies 10 years into the mortgage, the mortgage would be paid in full by the credit life insurance policy. Credit life insurance can protect co-signers, whose partner or spouse might not be able to afford to keep up with payments on their own.

The Bottom Line

Adjustable life policies provide the flexibility that most traditional policies do not. However, the frequency of allowable adjustments is restricted within set time frames. Requests must be made within an allotted period and meet the guidelines set by the insurer.

The variability in adjustments can create a policy that mirrors either term life insurance or whole life insurance. Effectively, adjustable life insurance policies allow policyholders to customize their life insurance to meet current or anticipated needs.

As with any kind of permanent policy, it’s critical to research every firm that’s being considered to ensure that they’re among the best life insurance companies currently operating.

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Average Cost Basis Method: Definition, Calculation, Alternatives

Written by admin. Posted in A, Financial Terms Dictionary

Average Cost Basis Method: Definition, Calculation, Alternatives

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What Is the Average Cost Basis Method?

The average cost basis method is a system of calculating the value of mutual fund positions held in a taxable account to determine the profit or loss for tax reporting. Cost basis represents the initial value of a security or mutual fund that an investor owns.

The average cost is then compared with the price at which the fund shares were sold to determine the gains or losses for tax reporting. The average cost basis is one of many methods that the Internal Revenue Service (IRS) allows investors to use to arrive at the cost of their mutual fund holdings.

Understanding the Average Cost Basis Method

The average cost basis method is commonly used by investors for mutual fund tax reporting. A cost basis method is reported with the brokerage firm where the assets are held. The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned. For example, an investor that has $10,000 in an investment and owns 500 shares would have an average cost basis of $20 ($10,000 / 500).

Key Takeaways

  • The average cost basis method is a way of calculating the value of mutual fund positions to determine the profit or loss for tax reporting.
  • Cost basis represents the initial value of a security or mutual fund that an investor owns.
  • The average cost is calculated by dividing the total amount in dollars invested in a mutual fund position by the number of shares owned.

Types of Cost Basis Methods

Although many brokerage firms default to the average cost basis method for mutual funds, there are other methods available.

FIFO

The first in, first out (FIFO) method means that when shares are sold, you must sell the first ones that you acquired first when calculating gains and losses. For example, let’s say an investor owned 50 shares and purchased 20 in January while purchasing 30 shares in April. If the investor sold 30 shares, the 20 in January must be used, and the remaining ten shares sold would come from the second lot purchased in April. Since both the January and April purchases would have been executed at different prices, the tax gain or loss would be impacted by the initial purchase prices in each period.

Also, if an investor has had an investment for more than one year, it would be considered a long-term investment. The IRS applies a lower capital gains tax to long-term investments versus short-term investments, which are securities or funds acquired in less than one year. As a result, the FIFO method would result in lower taxes paid if the investor had sold positions that were more than a year old.

LIFO

The last in first out (LIFO) method is when an investor can sell the most recent shares acquired first followed by the previously acquired shares. The LIFO method works best if an investor wants to hold onto the initial shares purchased, which might be at a lower price relative to the current market price.

High-Cost and Low-Cost Methods

The high-cost method allows investors to sell the shares that have the highest initial purchase price. In other words, the shares that were the most expensive to buy get sold first. A high-cost method is designed to provide investors with the lowest capital gains tax owed. For example, an investor might have a large gain from an investment, but doesn’t want to realize that gain yet, but needs money.

Having a higher cost means the difference between the initial price and the market price, when sold, will result in the smallest gain. Investors might also use the high-cost method if they want to take a capital loss, from a tax standpoint, to offset other gains or income.

Conversely, the low-cost method allows investors to sell the lowest-priced shares first. In other words, the cheapest shares you purchased get sold first. The low-cost method might be chosen if an investor wants to realize a capital gain on an investment.

Choosing a Cost-Basis Method

Once a cost basis method has been chosen for a specific mutual fund, it must remain in effect. Brokerage firms will provide investors with appropriate annual tax documentation on mutual fund sales based on their cost basis method elections.

Investors should consult a tax advisor or financial planner if they are uncertain about the cost basis method that will minimize their tax bill for substantial mutual fund holdings in taxable accounts. The average cost basis method may not always be the optimal method from a taxation point of view. Please note that the cost basis only becomes important if the holdings are in a taxable account, and the investor is considering a partial sale of the holdings.

Specific Identification Method

The specific identification method (also known as specific share identification) allows the investor to choose which shares are sold in order to optimize the tax treatment. For example, let’s say an investor purchases 20 shares in January and 20 shares in February. If the investor later sells 10 shares, they can choose to sell 5 shares from the January lot and 5 shares from the February lot.

Example of Cost Basis Comparisons

Cost basis comparisons can be an important consideration. Let’s say that an investor made the following consecutive fund purchases in a taxable account:

  • 1,000 shares at $30 for a total of $30,000
  • 1,000 shares at $10 for a total of $10,000
  • 1,500 shares at $8 for a total of $12,000

The total amount invested equals $52,000, and the average cost basis is calculated by dividing $52,000 by 3,500 shares. The average cost is $14.86 per share.

Suppose the investor then sells 1,000 shares of the fund at $25 per share. The investor would have a capital gain of $10,140 using the average cost basis method. The gain or loss using average cost basis would be as follows:

  • ($25 – $14.86) x 1,000 shares = $10,140.

Results can vary depending on the cost-basis method chosen for tax purposes:

  • First in first out: ($25 – $30) x 1,000 shares = – $5,000
  • Last in first out: ($25 – $8) x 1,000 = $17,000
  • High cost: ($25 – $30) x 1,000 shares = – $5,000
  • Low cost: ($25 – $8) x 1,000 = $17,000

From strictly a tax standpoint, the investor would be better off selecting the FIFO method or the high-cost method to calculate the cost basis before selling the shares. These methods would result in no tax on the loss. However, with the average cost basis method, the investor must pay a capital gains tax on the $10,140 in earnings.

Of course, if the investor sold the 1,000 shares using the FIFO method, there’s no guarantee that when the remaining shares are sold that $25 will be the selling price. The stock price could decrease, wiping out most of the capital gains and an opportunity to realize a capital gain would have been lost. As a result, investors must weigh the choice as to whether to take the gain today and pay the capital gains taxes or try to reduce their taxes and risk losing any unrealized gains on their remaining investment.

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