Hi Rob,
These are both accounting type terms. If we are looking at our inventory of stocks and mutual funds, Uncle Sam asks us to decide what way we will figure our taxes as we buy and sell shares of stock. Further, Uncle Sam asks us to be uniform in our decision.
LIFO stands for "Last In, First Out." This mean that the last shares purchased in one stock are the first ones sold, for tax calculation purposes.
FIFO stands for "First In, First Out." This means that the first shares purchased are the first ones sold, for taxes.
There is another method that is allowable - Average Cost Basis. This is most commonly used with mutual funds. This is the sum total of all costs to purchase shares including reinvested distributions averaged by the number of shares represented.
If we buy 1000 shares of XYZ at $10 per share, that is our base cost (plus commissions, etc.). If 5 years later we sell all of it, there's no need to differentiate between LIFO and FIFO. However, let's say that we own the full 1000 shares for two years without selling any. During that two years, we add an additional 300 shares (100 @ $8-1/2, 100 @ $7-1/2 and 100 @ $7), because the price becomes more favorable and AIM suggests we buy. Now, when AIM says to "Sell 100 shares @ $10-1/2", which shares are we selling?
There are three potential answers:
FIFO - We're selling original shares. The tax calculation is the proceeds of $1050 minus the cost of $1000 or a $50 capital gain. (I'm keeping this simple without the added costs of commissions, etc.)
LIFO - We're selling the LAST shares. The tax calculation is the proceeds of $1050 minus the cost of $700 or a $350 capital gain.
Average Cost Basis - Here we add all purchases and divide by the total number of shares. $10,000 + $850 + $750 + $700 = $12,300. Total shares is 1300. $12,300/1300 is $9.462 average. The tax calculation is the proceeds of $1050 minus the cost of $946.20 or a $103.80 capital gain.
Now you see why Uncle Sam wants us to be consistent year to year and in each class of security we use.
I have always used FIFO for my individual stocks. It's easy and keeps my stock inventory "fresh". For Mutual Funds, I have always used Average Cost Basis. Again, it's easier for me than the other alternatives.
The benefit of any particular method over another could be debated in a fashion not dissimilar to the old "chicken and egg" story. However, in the long run, it seems to all come out in the wash.
For the AIM user, it's interesting to note that sometimes AIM will have us buy deeply into a market price dip and then have us sell shares off BELOW our initial purchase price as it starts to recover. In this case, the shares are being sold at a LIFO profit, but a FIFO loss. Using LIFO for tax calculations, you pay some tax. Using FIFO, there's a loss!
Hope this helps more than it confuses!!
Best regards, Tom |
