Understanding FIFO in Investing and Accounting
First-In, First-Out (FIFO) is a widely used accounting method that assumes the first items purchased (inventory or securities) are the first to be sold. Think of it like eating jelly beans from a jar: FIFO means you consume the oldest jelly beans first. In investment terms, FIFO helps determine which shares you sold when you trade securities bought at different times and prices.
Why FIFO Matters for Investors
The method you use to identify which shares you sold impacts your cost basis—the original purchase price of those shares. Your cost basis is essential because it determines your capital gain or loss, which affects your tax liability. FIFO is the default cost basis method used by most brokers and accepted by the IRS if you do not specify otherwise.
How FIFO Works in Practice
Suppose you purchase shares of a stock at different times:
- January 1: 100 shares at $10 each
- March 1: 150 shares at $12 each
- June 1: 200 shares at $15 each
If you sell 250 shares on September 1 at $20 per share, FIFO assumes you sold the oldest shares first:
- 100 shares purchased on January 1 at $10
- 150 shares purchased on March 1 at $12
Capital Gain Calculation:
- For the first 100 shares: (100 * $20) – (100 * $10) = $2,000 – $1,000 = $1,000 gain
- For the next 150 shares: (150 * $20) – (150 * $12) = $3,000 – $1,800 = $1,200 gain
Total capital gain: $2,200
This gain is taxable, with rates depending on how long you held the shares (long-term vs. short-term).
Comparing FIFO with Other Cost Basis Methods
The major alternative to FIFO is Specific Identification, where you explicitly choose which shares to sell. This provides greater control over your taxable gains or losses. For example, you might sell the most recently purchased shares with a higher cost basis first to minimize gains.
When to use FIFO:
- Simplicity: FIFO is straightforward and often the default.
- Rising markets: Might lower short-term taxable gains by selling older shares bought at lower prices.
When FIFO might not be ideal:
- If you want to minimize taxes actively, Specific Identification can provide more strategic control.
- In markets with different purchase prices over time, selling higher-cost shares first may reduce taxes.
Who Uses FIFO?
FIFO mainly applies to investors selling stocks, bonds, or mutual funds in taxable accounts. It does not generally apply to tax-advantaged retirement accounts like IRAs or 401(k)s, which have different tax rules.
Tips to Manage FIFO Effectively
- Know your brokerage’s default policy: Most use FIFO unless you specify otherwise.
- Specify your sale lots if needed: Use Specific Identification for tax planning.
- Keep detailed records: Document purchase dates, prices, and quantities.
- Consult professionals: Tax advisors can help select the best strategy.
Common Misunderstandings
- FIFO isn’t always the best for tax savings.
- Not specifying a method defaults to FIFO, which might increase taxes.
- FIFO is different from LIFO (Last-In, First-Out), which the IRS does not allow for securities.
- Watch for wash sale rules, which affect loss deductions.
FAQs
Can I switch between FIFO and other methods?
You can choose Specific Identification on a trade-by-trade basis, but FIFO is often the default if not specified.
Does FIFO apply to all my investments?
FIFO applies to taxable brokerage accounts but not directly to tax-advantaged accounts until withdrawal.
How do I know which shares were sold?
Brokerage statements and tax documents, like Form 1099-B, indicate the method used.
Will FIFO increase taxes?
It depends on purchase prices and market conditions. FIFO often realizes gains from older, lower-cost shares first, affecting tax outcomes.
Sources
- IRS Publication 550, Investment Income and Expenses – https://www.irs.gov/publications/p550
- Investopedia: First-In, First-Out (FIFO) – https://www.investopedia.com/terms/f/fifo.asp
- NerdWallet: FIFO vs. Specific ID: Which Stock-Sale Method Is Best? – https://www.nerdwallet.com/article/investing/fifo-vs-specific-id-which-stock-sale-method-is-best