Average cost basis

The average cost basis method calculates your cost basis by averaging the purchase price you paid across all shares you own of a given holding. If you bought 100 shares at $50, then 100 at $100, your average basis is $75. When you sell, all shares are treated as sold at that average price. It is simple but rarely the most tax-efficient basis method.

How averaging works

Suppose you buy a mutual fund over ten years with reinvested dividends:

• Year 1: Buy $10,000 worth at NAV $50 = 200 shares
• Year 2: Reinvest $500 dividend at NAV $55 = 9.09 shares
• Year 3: Reinvest $600 dividend at NAV $60 = 10 shares
• (continues for ten years)

By year 10, you own 2,500 shares acquired at various prices. Instead of tracking each lot—with its own cost basis—the average cost method takes the total amount you paid ($30,000) divided by total shares owned (2,500), yielding an average basis of $12.

If you sell 500 shares at $15 per share, your gain is $500 per share × 500 = $250,000. Under average cost, your cost per share is $12, so your gain is ($15 - $12) × 500 = $1,500 gain. Simple.

When average cost is used

Average cost is most common with mutual funds, especially older accounts opened before electronic lot tracking was standard. Many mutual fund companies default to average cost; you must affirmatively elect a different method.

For stocks and ETFs, specific identification or FIFO are more common.

Advantages

Simplicity. You do not need to track individual lots or make decisions about which lot to sell. Everything is averaged; the math is straightforward.

Transparency. Your broker or mutual fund company calculates the average for you. No room for error in lot selection.

Disadvantages

Tax inefficiency. In most scenarios, specific identification—where you choose to sell the highest-cost lot—produces a lower gain and lower tax. Averaging forces you to treat all shares equally, which is suboptimal when bases vary widely.

Example of inefficiency: Suppose you own 100 shares of a stock: 50 bought at $50 and 50 bought at $150. Your average basis is $100. If the current price is $200, selling 50 shares under average cost gives a gain of ($200 - $100) × 50 = $5,000. Under specific identification, you would sell the 50 high-basis shares, giving a gain of ($200 - $150) × 50 = $2,500. Averaging costs you $2,500 extra in taxable gain.

Lock-in for mutual funds. Once you elect average cost for a mutual fund, switching to another method requires IRS approval. You cannot easily switch strategies later.

Election and compliance

To use average cost, you must affirmatively elect it with your broker or mutual fund company. The election typically applies to all transactions in that security within that account. Once made, you must use it consistently. Changing methods requires IRS Form 3115 (Application for Change in Accounting Method) and may require retroactive amended returns.

Comparison with other methods

• Specific identification is usually more tax-efficient because you choose the highest-cost lot to minimize gains.
• FIFO can be efficient if your oldest lots have high bases, but is often inefficient.
• LIFO can be efficient if recent purchases are at higher prices.

See also