Tax Traps: Select the Right Cost Basis Method
- Every brokerage platform has its own list of cost basis choices.
- There are pros and cons to each method.
- By specifying the lots you want to sell, you gain control of the tax consequences.
This is the last of a series of articles appearing each Monday before April 15, highlighting important tax concepts related to ETF investing.
Not too long ago, a very seasoned and knowledgeable investor shared a story of a mistake he recently made. He meant to buy 300 shares of the Vanguard Total Stock Market ETF (VTI) but mistakenly punched an extra zero and bought 3,000 instead.
He quickly realized his mistake and sold the 2,700 shares he accidentally bought. The ETF was only up slightly, and he used the Minimum Tax (MinTax) cost basis method on Vanguard’s brokerage platform. He was shocked to learn he just realized a long-term capital gain of about $150,000.
Vanguard lists the following priorities it uses for sales with the MinTax method and also states, “The shares with the most favorable tax rate might not be the shares with the lowest gains.”
- Short-term capital loss from largest to smallest
- Long-term capital loss from largest to smallest
- Short-term zero gain or loss
- Long-term zero gain or loss
- Long-term capital gain from smallest to largest
- Short-term capital gain from the smallest to largest
Because the recently purchased lot of VTI had a tiny short-term gain, it was last in the prioritization of sales and his prior lots with large long-term gains were sold. Anyone could have made a mistake like this, and I applaud this investor for sharing this story and helping others to avoid a similar situation.
Cost Basis Choices
Every brokerage platform has its own list of cost basis choices. The following comes from Fidelity.
- First In, First Out (FIFO)
- Intraday First In, First Out
- Last In, First Out (LIFO)
- High-cost
- Low-cost
- High-cost long-term
- High-cost short-term
- Low-cost long-term
- Low-cost short-term
- Tax sensitive short-term
- Tax sensitive
Pros and Cons
There are pros and cons to each of the above, but Fidelity also gives the choice to “sell specific shares.” Vanguard has “Specific Identification (SpecID),” and Charles Schwab has “Specified Lots.”
By specifying the lots you want to sell, you gain control of the tax consequences that will incur and can apply to your own situation. You may have tax loss carryforwards or be in a 0% Federal long-term capital gains rate.
In general, we typically want to defer recognizing gains. While choosing specific shares to sell is far more complex than the other “set it and forget it choices,” we have to remember that taxes are fees too.
Elisabeth Kashner, director of ETF research and analytics at FactSet, concurred stating, “The best practice for tax management is to specify the exact lot, so that the seller can control the realization of capital gains or losses.”
A New Complication
Whenever buying and selling ETFs, I’ve long recommended using limit orders to protect against volatility and illiquidity as a free insurance policy. The extreme example I give is the 2010 flash crash, in which markets plunged for 15 minutes due to a trading glitch. They quickly recovered.
But someone using a market sell order during that unfortunate period was likely shocked to receive far less than the price they saw even seconds earlier. So, setting a sell limit order of, say, 0.1% less than the last price protects against sudden price plunges. This is called a marketable limit order.
A Vanguard spokesperson sent me a document entitled Considerations for ETF trading strategies, which suggests using a limit or marketable limit order. The complication is that starting this past January, Vanguard no longer allows any type of limit orders using SpecID.
When I pointed this out, Kashner told me, “If it is not possible to both use a limit order and control the realization of gains/losses, in many cases I would choose tax lot specification over order type selection, as getting unfavorable tax treatment is likely to be far more expensive than incurring a bit of market slippage.” I concur.
The Bottom Line on Tax-Efficient Investing
I’ve always said investing is simple, but I never said taxes were. Over many years, tax-efficient investing is likely to have a much bigger impact than expense ratios.
Using the right cost basis method when selling an ETF is critical. Though choosing the right lots to sell is by far the most complex cost-basis method, it’s typically worth the complexity.
