Tax planning and compliance for investors
Free Online Guides
A somewhat more complicated (but potentially tax-saving) alternative to the single-category averaging method.
This page explains the double-category averaging method for determining the basis of mutual fund shares you sell. This method is more complicated than the single-category method, and doesn't necessarily produce better results — but we explain it here for those who think it may be useful, or who have already elected this method.
We assume you're already familiar with the single-category averaging method when you come to this page. If not, visit Single-Category Averaging Method and then return here.
When you use the double-category method, you keep track of your average basis for short-term shares separately from your average basis for long-term shares. You're allowed to choose at the time you make a sale whether you're selling long-term shares or short-term shares. This added flexibility may permit you to save tax dollars on particular sales. But you can also end up paying more tax under this method because you can't average the basis of your short-term shares with the basis of your long-term shares.
The double-category averaging method is somewhat complicated. When you use the single-category method you don't need to keep track of your basis in particular shares. You merely need to know the total basis, and the total number of shares. But when you use the double-category method you need to know the basis of particular shares. That basis will start out being included in the average basis of your short-term shares. A year and a day after the day you acquired those shares, their basis is no longer part of the average short-term share basis because these shares have moved into the long-term category.
The tax benefit of this method comes primarily from its greater flexibility. For example, you may purchase shares in a mutual fund over a period of many years when its value was rising. Then you may have occasion to withdraw money from the fund shortly after a drop in value. If you're using the single-category method, you may recognize a gain despite the recent drop in value. Your average basis is still lower than the current value because you bought some shares many years ago. But if you use the double-category method, you can specify that you're selling the short-term shares, and report a short-term loss instead of a long-term gain. The result: lower taxes.
Even if you don't specify which shares you're selling, the double-category method can produce savings. This might happen, for instance, if you recently bought shares after a significant decline in the value of the fund. The double-category method would keep the recent, low-basis shares out of the calculation of the average basis of the long-term shares you sold.
Note that the tax benefit of using this method often depends on a decline in the value of a mutual fund. Because most funds go up over the long term, these savings opportunities may not occur very often.
If you're willing to endure the complexity of the double-category averaging method to obtain the benefits described above, you should consider not using any averaging method, and specifically identifying the shares you sell at the time of each sale. This method provides even greater flexibility, and the complexity may not be much greater than using the double-category method.
|That Thing Rich People Do||The fastest, easiest way to learn the principles of investing.|
|Our complete guide to Roth IRAs and Roth accounts in 401k and similar plans: choosing, creating, building and using these accounts.|
|Consider Your Options|
|A plain-language guide for people who receive stock options or other forms of equity compensation.|
|Equity Compensation Strategies|
|A text for financial advisors and other professionals who offer advice on how to handle equity compensation including stock options.|
|Capital Gains, Minimal Taxes|
|Tax rules and strategies for people who buy, own and sell stocks, mutual funds and stock options.|