The tax strategy used to determine your gains or losses on an individual transaction can impact the taxes you are responsible for paying. For example, short-term gains are taxed at a higher rate than long-term gains, and capital losses can offset capital gains for tax purposes. It is in your best interests to understand the tax implications of your decision at the time of a transaction.
Please note, your tax strategy can only be changed from the day following the trade execution up to and including the settlement date.
The tax strategies available at Scottrade are:
FIFO (First In, First Out)
The shares you acquire first are the shares that are sold first. Think of this like the milk aisle at a large grocery store - the shelf is loaded back-to-front from the refrigerated room in back, so the first gallon of milk that the grocer slides into the shelf is the first one a customer sees. The first gallon of milk put in is the first gallon of milk that is taken out.
FIFO is well suited for accounts with few individual tax lots and limited differences in price per share for basis. Investors with various lot positions bought over an extended period of time at different prices should consider the tax consequences of using FIFO when selling those positions.
FIFO is Scottrade's default tax strategy.
LIFO (Last In, First Out)
The most recently acquired shares are sold first. This is more like the canned goods aisle at the grocery store. If the grocer loads canned vegetables by pushing back the ones that are already on the shelf, then the most recently loaded cans are the ones in front for the customer to see. The last cans put on the shelf are the first cans to be taken off the shelf.
LIFO creates shorter term transactions with potentially lower gains or losses as the current sale price may be closer to the purchase price of the most recently acquired shares. The tendency to being taxed at ordinary rates (tax rate of short-term gains) tends to impact investors' choice when using LIFO.
HIFO (Highest In, First Out)
The shares with the highest cost basis are sold first. Think of this one like a jewelry store heist where the thieves know what they're after - the highest-priced items are the first to go.
HIFO is specifically designed to limit your gain amounts, which creates lower taxable capital gains, but it also maximizes the losses you will incur. Because HIFO doesn't distinguish between long-term and short-term positions, it may sell a short-term position even though the tax rate is higher, and it may sell a long-term position that could have offered greater opportunity to limit capital gains in a rising market. HIFO is attractive to investors who have positions that have roughly the same duration (all short-term or all long-term), but should be monitored in portfolios with a mix of position lengths.
The Gain/Loss & Tax Center will determine the best lot to sell to minimize your after-tax gains, thus lowering your tax burden. Lowering your tax burden often means lower realized gains, which can be a downside for investors looking for the maximum cash flow from their sales.
The Minimum Tax approach selects tax lots in the following order:
- Highest short-term loss
- Highest long-term loss
- Smallest long-term gain
- Smallest short-term gain
Minimum Tax minimizes overall portfolio taxable gains, assuming that short-term losses offset first against short-term gains, which are taxed at a higher rate.
Investors should use caution when selecting Minimum Tax as a global tax strategy because it takes into consideration duration before price, which may not result in true Minimum Tax in every situation. So, for example, even if the highest long-term loss is higher than the highest short-term loss, the short-term loss would be taken first, which would not necessarily result in the lowest after-tax gains.
The Gain/Loss & Tax Center will sell lots first that would realize the largest taxable gain, meaning you walk away with the highest possible capital gains. This strategy should be used with care since its ultimate effect is to increase your tax burden.
This strategy is designed to maximize gain and is most often used to take advantage of available realized losses that can offset gains.
Maximum Gain reverses the strategy of Minimum Tax, liquidating lots in the following order:
- Short-term gains
- Long-term gains
- Long-term losses
- Short-term losses
Also like Minimum Tax, the focus is on duration, so you are not guaranteed to get the Maximum Gain on every transaction.
Versus Purchase (VsPurchase) allows you to match a particular lot with a particular buy or sell order. Say for example you own three different 50-share lots of the same stock, all bought at different times for different prices. If you want to sell 50 shares, you can choose which 50 you want to sell to achieve your desired tax impact. Likewise, if you only want to sell 25 shares, you can choose the tax lot from which those 25 are taken.
This can potentially allow you to control whether your gains are long-term or short-term and higher or lower. At Scottrade, versus purchase is the only tax strategy which cannot be used as a default tax strategy but only on a trade-by-trade basis.
Average cost takes the average cost basis of all of your positions of a particular security and uses that number for calculation of gains and losses. The average is calculated by aggregating the cost basis of all tax lots of identical shares and dividing by the total number of those shares in your account. Average cost can only be used for mutual funds at Scottrade.
To change the tax strategy used by Scottrade on a particular position, or to update your default tax strategy, visit the Gain/Loss and Tax Center in your account.
Scottrade does not provide tax advice. The material provided in this article is for informational purposes only and Scottrade is not responsible for any errors or omissions. Please consult your tax or legal advisor(s) for questions concerning your personal tax or financial situation.