Dollar cost averaging is a method of buying into an investment position over time. The goal is to avoid buying into an investment, such as common stock, at a temporarily high price and watching your investment decline in value immediately. The Internal Revenue Service (IRS) collects taxes on capital gains from your investments. There are strategies to use that may reduce your tax liability when selling stock acquired by the dollar cost averaging method.
Dollar Cost Averaging
If you dollar cost average, you buy numerous small amounts of the same stock on a regular basis. The theory is that, over time, you will be buying at high prices and low prices, but your cost basis on the entire position will average out to somewhere in between the high and low prices. When you sell the position, some shares may have a cost basis higher than the price at which you sell the entire position, but the shares bought at lower prices will theoretically make up for this.
Capital Gains Tax
When you make a profit selling stock at a higher price than you paid for it, you will pay capital gains tax on that profit. The amount of tax depends on how long you held the shares, and the longer the shares are held, the lower the tax rate. If you have losses on stock you have sold after holding long-term, you can match off those losses against both short and long-term gains. The tax law changes frequently regarding the treatment of short and long-term capital gains, so it is best to check with your accountant before selling stock to affect a particular tax strategy.
HIFO Tax Strategy
If you are dollar cost averaging, your position in a stock will consist of several different lots bought in at different times and different prices. When you sell some, but not all, of these shares, the U.S. tax code allows you to identify which shares you sold. This means that you can choose the highest cost lots purchased to lessen the amount of capital gains taxes you will have to pay. This cost-basis tax strategy is called highest-in-first-out referring to the fact that you are selling the highest-cost shares first.
If you bought some lots at higher prices than the price you sold the stock, and you held those lots for long enough to qualify as long-term capital losses, identify those lots as the ones sold so they can be used to offset gains in other stocks. Always consult your accountant regarding the latest IRS rules on treatment of capital gains and losses.
- Journal of Financial Planning; Can Taxes Save Dollar-Cost Averaging?; by Robert J. Atra, Ph.D., CFA, and Thomas L. Mann, Ph.D., CFP
- State Farm Mutual Automobile Insurance Company: What Is Dollar-Cost Averaging?
- CNN Money: 7 Steps -- Capital Gains Tax Guide
- IRS.gov: Ten Important Facts About Capital Gains and Losses