By: Edward J. Leach, CFP®, MBA
At HIGHLAND Financial Advisors, tax efficiency is a cornerstone of our investment management strategy. After all, it is not what you make but what you keep. One of the key strategies we use to achieve this is tax lot identification in our trading procedures.
Each time you purchase an investment, it creates a separate tax lot, even if you already own shares of the same investment. Managing these tax lots helps reduce realized capital gains, which are taxable when securities are sold in a taxable account. A capital gain occurs when the selling price of a security is higher than its purchase price, while a capital loss occurs when the selling price is lower than the purchase price.
Common Tax Lot Identification Methods
For mutual funds, there are three main tax lot identification methods:
First In, First Out (FIFO): The earliest acquired securities are sold first.
Average Cost: The average cost basis of all shares is used to calculate gains and losses.
Specific Share: A specific lot is chosen to be sold.
For stocks and exchange-traded funds (ETFs), the Last In, First Out (LIFO) method is another method where the most recently acquired securities are sold first.
Eligible Securities for Each Method
FIFO: Mutual Funds, ETFs, Stocks
LIFO: Mutual Funds, ETFs, Stocks
Average Cost: Mutual Funds
Specific Share: Mutual Funds, ETFs, Stocks
Example: Comparing Tax Lot Methods
Here is an illustration of how different tax lot identification methods can impact your taxes. Suppose you purchased 5,000 shares of XYZ mutual fund each year for the last five years, with purchase prices ranging from $20 to $30, and the mutual fund is currently trading at $35. You decide to sell 10,000 shares of XYZ mutual fund for a down payment on a new home and are in the 15% capital gains tax bracket. This example excludes any state-specific tax liabilities that may be realized.
Different tax lot identification methods yield different tax outcomes:
FIFO: Realizes gains of $125,000 and taxes of $18,750.
Average Cost: Realizes gains of $110,000 and taxes of $16,500.
Specific Share: By selecting lots 2 and 5, realize gains of $80,000 and taxes of $12,000.
The specific share method provides significant tax savings compared to FIFO and average cost methods, showing the importance of choosing the optimal tax lot identification method.
At HIGHLAND Financial Advisors, we consider each client’s tax situation every time we trade. For more information on minimizing taxes through tax lot selection, please contact a member of the team. We are here to help you achieve your financial goals.
Ed Leach, CFP®, MBA, is a Partner and Wealth Advisor at HIGHLAND Financial Advisors, LLC in Wayne, NJ, and works directly with clients advising them on their financial planning and investments. Ed’s work focuses on the unique needs of business owners, helping them extract value from their businesses while creating efficiencies in their business and personal financial plans. He is also a member of NAPFA, which is dedicated to serving fee-only advisors.