Many mutual fund investors don’t realize how selling a few units can trigger taxable events that depend not only on price movements but on which specific units are deemed sold. The First In, First Out (FIFO) rule is commonly used to decide that: units purchased earliest are treated as sold first. That simple principle determines cost basis, the split between short‑term and long‑term gains, and ultimately the tax you pay.
What FIFO means for mutual funds
FIFO (First In, First Out) means the units you bought first are the ones considered sold first when you redeem or switch units in a mutual fund. Each purchase creates a “lot” with its own purchase date and cost per unit. When you sell, the fund or your broker matches your sale against the oldest lot(s) first.
This matters because capital gains tax is calculated based on the difference between sale proceeds and the cost of the units sold. Since different lots often have different purchase dates and costs, FIFO can change both the size of your gain and whether it is classified as short‑term or long‑term.
How capital gains are computed under FIFO
Here’s the step‑by‑step of how FIFO affects the capital gains calculation:
- Identify lots: List your purchase lots by date and units bought.
- Match sales to oldest lots: When you sell N units, those units are taken from your earliest lot(s) until the sale quantity is covered.
- Compute gain per lot: For each lot used, calculate gain = (sale price per unit − purchase price per unit) × units sold from that lot.
- Classify holding period: Determine whether each lot sold meets the threshold for short‑term or long‑term treatment (this threshold varies by country and fund type).
- Apply tax rules: Apply the applicable tax rate or method to the short‑term and long‑term portions separately.
Example — a simple lump‑sum scenario
Imagine you made two purchases:
- 100 units at $10 each on Jan 1, 2020
- 200 units at $12 each on Jan 1, 2021
You sell 150 units on Jan 1, 2022 at $15 each. Under FIFO the sale matches the oldest units first:
- First 100 units sold come from the Jan 1, 2020 lot: gain = (15 − 10) × 100 = $500
- Next 50 units come from the Jan 1, 2021 lot: gain = (15 − 12) × 50 = $150
Total capital gain = $650. Whether parts of that $650 are short‑term or long‑term depends on your tax law’s holding‑period thresholds for those lots. Each lot is treated on its own timeline.
Example — a SIP (systematic investment plan) investor
SIP investors buy many small lots over time. Consider four monthly purchases:
- Jan: 50 units @ $10
- Feb: 50 units @ $11
- Mar: 50 units @ $12
- Apr: 50 units @ $13
You sell 120 units in November. FIFO will use Jan, Feb, Mar and 20 units from Apr. Each matched lot may have a different holding period, so part of your gain might be long‑term and part short‑term. That split affects total tax due.
Why FIFO matters to investors
- Determines cost basis: Older purchases often have lower costs and can create larger gains when sold first.
- Affects tax classification: Since each lot has its own holding period, FIFO can create a mix of short‑term and long‑term gains on a single redemption.
- Impacts tax timing: Selling older lots first could accelerate tax liability compared with selling newer lots.
- Reporting simplicity: FIFO is straightforward, but it can make tax planning more important for investors with many lots.
Common variations and rules to watch for
- Jurisdictional differences: Tax rates, holding‑period definitions and allowed cost methods vary by country. Some jurisdictions permit specific identification or average cost methods instead of FIFO.
- Fund or broker rules: Mutual fund houses or brokerages may default to FIFO, but they might also offer specific‑ID or average cost options—check your account settings and statements.
- Different rules by fund type: Equity and debt funds are often taxed differently (different holding‑period thresholds and rate or indexation rules).
Practical tips for managing capital gains under FIFO
- Keep detailed records: Save transaction confirmations and consolidated account statements that list lot dates and costs.
- Check your account method: Confirm whether your platform uses FIFO by default and whether you can choose another method.
- Plan redemptions: If you want to manage taxes, consider which lots would be sold under FIFO and how that affects the mix of short‑ and long‑term gains.
- Use tax harvesting carefully: Selling loss‑making lots to offset gains can be effective, but ensure the replacement purchases won’t trigger rules that disallow the loss.
- Consult a tax professional: Rules can be complex and change over time; a professional can help apply local laws to your situation.
FIFO is a simple principle, but its consequences for capital gains tax can be significant—especially for investors with many buy dates or regular SIPs. Knowing how your sales will be matched to earlier purchases helps you predict tax results and make smarter redemption choices.