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Suppose I bought $5,000 in Vanguard Total International Stock Index Fund over several installments, some before 2012 and some after 2012 (set to reinvest), and now it's worth $10,000.

I would like to convert $3,000 of it into high grade bonds by specifying the average cost basis method (it's currently unspecified for the given fund). I then plan to sell the remaining money in the fund next year, but then I intend to use the specific identification method.

Is that possible (the change to specific identification when I had used average cost for the initial sale)?

If so, does each installment of my original basis get scaled down by the same factor from the $3000 sale? Or what if the last installment was made three months ago: Since I'm theoretically selling part of that last installment, what determines whether I pay long-term or short-term capital gains? It would be black and white to determine which to use in FIFO or specific identification.

In general for a typical personal investor, is there usually a significant downside in effective after-tax returns from using the average cost basis instead of specific identification?

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You cannot change from the average cost method to the specific shares method (but switching in the other direction is OK). If you are planning on withdrawing $3000 this year and using the average cost method in redeeming these shares, and later, redeeming all the remaining shares in one transaction, then the question of switching to specific-shares method for the latter transaction is moot: you are redeeming all the remaining shares and no identification of specific shares to be redeemed is needed.

If you currently have 1000 shares purchased at an average cost of $9/share and you redeem 300 shares at $10/share to get the desired $3000 withdrawal, then you have a capital gain of $1/share or $300 total, and you are left with 700 shares which still have an average cost of $9/share. But, depending on when the 1000 shares were purchased (whether by paying cash or requesting that a distribution be reinvested in the fund), some part of the gain will be taxed as short-term capital gain and some as long-term capital gain. If, say, 100 shares were purchased less than a year before the sale date and the other 900 were purchased earlier, then (100/1000) = 10% of the capital gain is short-term gain and (900/1000) = 90% of the capital gain is long-term gain. Is there a disadvantage to the average cost method as compared to the specific-shares method? Yes, because depending on the details of the individual purchase/reinvestment transactions, one might be able to cherry-pick those shares which have incurred the least gains (or possibly even have losses, having been bought at more than the current share price) and choose to redeem those losers instead. But, then you also need to have detailed records of previous transactions which may extend back many years....

  • Thanks. Re: the second part of the second question: If I just put in $100 a month ago and it appreciated to $110, and then I make the aforementioned $3000 partial sale, do I have to pay short term capital gains or long term gains? It's not clear to me since I'm not specifying whether the $3k avg cost basis partition counts as a sale of the $100 (i.e., whether the $3k captures a component of the $100 and then degenerates to STCG). It would seem pretty difficult to sell with LTCG it seems if the fund is set to reinvest dividend distributions. – Wuschelbeutel Kartoffelhuhn Nov 19 '17 at 22:38
  • @WuschelbeutelKartoffelhuhn+ when you use average basis method, your holding period is computed as FIFO. See pub 550 online or downloadable from 'search forms&instructions' on the homepage. (PS: I used to hold VTIAX and I don't recall any years with +120% appreciation.) – dave_thompson_085 Nov 22 '17 at 7:22

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