Basis – often referred to as a cost basis or tax basis – represents the purchase price of an investment, adjusted for stock splits and dividends. It refers to money that has already been taxed and, when compared to the current value of an investment, is used to calculate the taxable gain on an investment.

Qualified vs. Non-Qualified Money

In the context of taxation, there are two types of investment contributions: qualified and non-qualified.

The most common types of qualified investment plans are traditional individual retirement accounts (IRAs). Contributions to IRAs are tax-qualified, meaning the contribution has not been taxed. When withdrawals are taken from an IRA, there is no distinction between contributions and earnings. The entire withdrawal is taxable. Qualified money is not considered a basis.

Non-qualified investments – including most brokerage accounts and annuities – are funded with money that has already been taxed. Contributions to these investments are considered a basis. Only realized gains such as the sale of an appreciated investment or a received dividend are taxable.

Types of Bases

There are three types of bases that broker/dealers are required to offer to their customers: average cost; first in, first out; and specific identification.

The average cost method is usually the most simple. Typically used for mutual fund shares, the average cost method spreads gains and losses evenly across all owned shares.

“First in, first out” can be used for all types of investments. It involves selling shares in the order that they were bought and is a hands-off approach. You don’t have to select the shares you sell but this approach could be less tax-efficient than other methods.

Finally, the specific identification method requires rigorous record-keeping. Every time you sell shares of a stock or mutual fund, you will have to select the exact shares to liquidate. It’s a lot of work but could result in the greatest tax benefits.

Basis in Retirement Planning

Knowing the amount of basis in your portfolio is extremely important when it comes to planning for retirement. When you start relying on your investments for income rather than growth, your basis becomes tax-free income. That’s why it’s vital that you record it correctly when you make an investment.

Many people also use annuities as retirement planning tools. These products have a unique way of treating basis that results in a predictable tax bill. Annuities use “first in, first out” during their deferral phase, but things change once income begins.

When you convert an annuity into a stream of retirement income, the insurance company looks at your basis and calculates the percentage of each income payment to consider as a tax-free return of principal. This percentage is called an exclusion ratio. It can help keep your tax situation constant from year to year.

Gifts and Inheritances

Many people consider gifts and inheritances part of retirement planning.

If you gift an investment to someone, the recipient receives transferred basis. This means that their cost basis is the same as yours.

If you pass on an investment after you die, however, the beneficiary will receive stepped-up cost basis. This means that the new cost basis will be the market value of the investment at the time of your death.