When you sell a capital asset for profit you have to pay capital-gains taxes. If you buy shares of a stock at different points in time, and then sell some of those shares, the you would typically assume that you sold your longest held stock first. This is known as the first-in first-out (FIFO) method. However, in some cases you can also use the last-in, first-out (LIFO) method. Depending on your circumstances, there can be tax benefits to using this approach rather than the FIFO method.
Last In First Out
If the stocks you own steadily rise in value, then you have the largest capital gains and the highest tax burden on the stocks you bought first because you don't pay taxes on your return of premium. If you want to minimize your taxes you can use the specific identification method to identify the stocks that you sell first as the stocks that you bought most recently. You are effectively paying your taxes by using the LIFO method, although you are officially using the specific identification method.
First In Last Out
LIFO can minimize your taxes in the short-term, the FILO part of the equation could cause you to pay more taxes in the long term. You pay capital gains tax at a rate of 15 percent on sales of stock that you have held for more than one year. You have to pay ordinary income tax on stocks sales if you held the stock for one year or less, and ordinary income tax rates run as high as 35 percent. Therefore, if you use the LIFO or FILO method you can reduce your taxable gains but you may end up paying tax at a higher rate.
Tax qualified accounts are investments that are sheltered from federal income taxation such as 401(k)s or individual retirement accounts (IRAs). You can hold stocks within tax qualified accounts and you can sell these stocks without restriction as long as you do not take the sale proceeds out of the tax qualified account. When you eventually withdraw money from a tax qualified account, you have to pay ordinary income tax on your entire withdrawal. Therefore, you do not need to use FIFO, LIFO or the specific identification method because you have the same capital gains, and pay the same rate of tax on all of your money.
The Internal Revenue Service taxes stock sales using the FIFO method, unless you can provide proof that you used the specific identification method to sell your stocks in a different order. If you want your broker to identify the stocks that you plan to sell then you must provide your broker with the original purchase date and purchase price of those stocks. Your broker must give you written confirmation that those specific stocks where the ones that were sold. You cannot retroactively characterize your stock sale as a LIFO or FILO sale.
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