Take tax hit to move to lower cost fund?

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lairdb
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Take tax hit to move to lower cost fund?

Post by lairdb »

I think I've modeled this correctly by brute force, but I'm certain there's an easier way to arrive at the answer -- I just don't have my head wrapped around the math sufficiently.

Suppose I have an investment in a market index fund with a higher-than-desirable ER. However, moving it to a lower ER fund would require taking the LT CG hit.

For the purpose of the model, let's assume that BSPAX, with an ER of 0.48%, and VOO, with an ER of 0.05% are both S&P index based, and so both generate the same raw return*. If I've already got 50.54% unrealized gains in BSPAX, with California's 33% combined LTCG rate, my (crude, brute force, annualized) model says that it takes 27 years to recover the tax hit.

(*It wasn't obvious to me until I played with the model that the assumed return washes out; whether I assume 6%, 1%, or 50% annual return, the time to recoup the tax hit stays the same.)

1) Back to being a math dummy: it seems to me that I ought to be able to solve for Y (years to recover) given UGP (unrealized gain percent), ER1, and ER2 -- but it's not coming together in my head.

2) (At which point I think it should be trivial to input Y years before beginning a draw-down and solve for how much better the ER needs to be to compensate for a given UGP, which might also be interesting.)

3) In any case, the brute model suggests I might as well leave this particular money where it is, and accept being nibbled by the ER for a while in return for deferring the tax hit. Tax policy changes could make a mess of this, obviously, but what else am I missing that should be factored in? Is there some split-the-baby strategy? Did I goof the basic math? Did I miss a wiki section explaining this?

Thanks.
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Steelersfan
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Re: Take tax hit to move to lower cost fund?

Post by Steelersfan »

I've got a similar situation with an American Funds fund. The difference in ER's is a little more but my marginal tax rate is less.

I came out with a payback of 15 years.

I'm staying put. Too many other things can happen over that time period.

One thing I had to factor in was that I have existing capital gains tax losses from tax lost harvesting which I would lose. Those are offsetting regular income at $3,000 per year.
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joe8d
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Re: Take tax hit to move to lower cost fund?

Post by joe8d »

If I've already got 50.54% unrealized gains in BSPAX
What is the total value of your BSPAX fund?
All the Best, | Joe
bdpb
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Re: Take tax hit to move to lower cost fund?

Post by bdpb »

Presumably, both funds are the same tax efficiency (given index funds), otherwise this should be in your calculation, too.

Are there different tax lots? Are there some lots with less gains? If so, you may only want to sell some of it.

Obviously, stop dividend reinvestment.

Does selling a portion each year allow for lower taxation?

Do you make charitable contributions? Gift away the CG.

Do you plan to sell after 27 years? If so, then it's ok to make the change.
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lairdb
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Re: Take tax hit to move to lower cost fund?

Post by lairdb »

joe8d wrote:
If I've already got 50.54% unrealized gains in BSPAX
What is the total value of your BSPAX fund?
Does it matter to the calculation or decision? Enough that getting out all at once would kick me into a higher bracket if it were OI, but I don't think it matters here, does it?

bdpb wrote:Presumably, both funds are the same tax efficiency (given index funds), otherwise this should be in your calculation, too.
I would think so -- within reasonable levels of accuracy, this should be apples to apples.
bdpb wrote:Are there different tax lots? Are there some lots with less gains? If so, you may only want to sell some of it.
Ha -- good point. The BSPAX is all one lot, so nothing there; the MDSKX (similar situation, but only 21% gain) has a 2006 lot that's about 15% of the total that is effectively flat; I'll exit that for sure. The rest of the MDSKX would need about 9 years to recoup the CG tax, so it probably deserves a considered look.
bdpb wrote:Obviously, stop dividend reinvestment.

Does selling a portion each year allow for lower taxation?
Never did reinvest on these, so no problem there.

Unless we anticipate CG rates going down, how would spreading out the sell affect the eventual tax consequences?
bdpb wrote:Do you make charitable contributions? Gift away the CG.

Do you plan to sell after 27 years? If so, then it's ok to make the change.
Charity: Some, but not enough to matter to this calculation.

Eventual sale timing: that's where it gets interesting, I suppose -- I'm late 40s and projecting about 10 more years of salaried employment, so I don't imagine selling before then. Between them, though, these two holdings each represent about 20% of my AA, so the effects are potentially significant, and the payback on existing the MDSKX is somewhere around 9-10 years. I'm of the "die broke" mindset, so they will get sold eventually, but that should be over a period between 10 and 30 years from now (and possibly in a lower state tax venue.)
ajcp
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Re: Take tax hit to move to lower cost fund?

Post by ajcp »

lairdb wrote:Unless we anticipate CG rates going down, how would spreading out the sell affect the eventual tax consequences?
If you were close to the next marginal cg bracket it would make a difference, but I'm guessing you're not.
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lairdb
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Re: Take tax hit to move to lower cost fund?

Post by lairdb »

ajcp wrote:
lairdb wrote:Unless we anticipate CG rates going down, how would spreading out the sell affect the eventual tax consequences?
If you were close to the next marginal cg bracket it would make a difference, but I'm guessing you're not.
I keep forgetting that there are CG brackets -- yes, I'll have to keep an eye on that, or I'll end up bumping into the 20% LTCG bracket. Thanks.
barnaclebob
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Re: Take tax hit to move to lower cost fund?

Post by barnaclebob »

What about using it to rebalance into bonds as needed to spread out the tax hit?
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Watty
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Re: Take tax hit to move to lower cost fund?

Post by Watty »

assume that BSPAX, with an ER of 0.48%, and VOO, with an ER of 0.05%

If I've already got 50.54% unrealized gains in BSPAX, with California's 33% combined LTCG rate
You are making this way too complex.

Forget the theory and just run a few numbers.

For $1000 in BSPAX you pay an excess ER of 0.43% (.48-.05) or $4.20 a year.

if you sell the BSPX and buy VOO then you pay ($1000 * 50.54% * 33%) $167 in taxes and have $833 in VOO.

Either of them would pay a 1.8% dividend.

BSPX $1000 * 1.8% =$18
VOO $833 * 1.8% =$15

Difference = $3 in the favor of BSPX

A very conservative return on the mutual fund is 5% but you would have $167 more of BSPX

BSPX $167 * 5% = $8.35

But you will pay 33% capital gains taxes when eventually sell it and be left with;

8.35 * 66% = $5.51.

So the net if you stay with BSPX is
- $4.20 in lost expense ratio savings
+ $3 in dividends
+ 5.51 in extra after tax growth
for a total of $4.31 you would come out ahead the first year if you stuck with BSPX.

The differences would compound over time too.
Last edited by Watty on Tue Jan 07, 2014 4:18 pm, edited 1 time in total.
technovelist
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Re: Take tax hit to move to lower cost fund?

Post by technovelist »

I'm sure you've considered this, but if you think you might move to a lower-tax state before taking the money out, that would suggest waiting until then to sell.
In theory, theory and practice are identical. In practice, they often differ.
billern
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Re: Take tax hit to move to lower cost fund?

Post by billern »

What is your present value factor for looking at the cashflows (taxes paid now versus the future)? What are your assumptions regarding future tax rates? Is your other case holding the fund until death (avoid capital gains) or are you assuming the appreciation will be subject to income tax in a future year?
kaneohe
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Re: Take tax hit to move to lower cost fund?

Post by kaneohe »

Watty wrote:
assume that BSPAX, with an ER of 0.48%, and VOO, with an ER of 0.05%

If I've already got 50.54% unrealized gains in BSPAX, with California's 33% combined LTCG rate
You are making this way too complex.

Forget the theory and just run a few numbers.

For $1000 in BSPAX you pay an excess ER of 0.43% (.48-.05) or $4.20 a year.

if you sell the BSPX and buy VOO then you pay ($1000 * 50.54% * 33%) $167 in taxes and have $833 in VOO.

Either of them would pay a 1.8% dividend.

BSPX $1000 * 1.8% =$18
VOO $833 * 1.8% =$15

Difference = $3 in the favor of BSPX

A very conservative return on the mutual fund is 5% but you would have $167 more of BSPX

BSPX $167 * 5% = $8.35

But you will pay 33% capital gains taxes when eventually sell it and be left with;

8.35 * 66% = $5.51.

So the net if you stay with BSPX is
- $4.20 in lost expense ratio savings
+ $3 in dividends
+ 5.51 in extra after tax growth
for a total of $4.31 you would come out ahead the first year if you stuck with BSPX.

The differences would compound over time too.
Watty...........there may be a few tweaks needed in your model..........you assumed a gain of 500 of the 1000 current value.
That is an appreciation of 100% rather than the 50% in OP. Shouldn't the gain be more like 333 on a basis of 667? Selling the current position resets the basis higher so that when you sell, there will less tax due than if you held. Both of these are less favorable to holding the current position so possibly the current advantage swings to selling and then it may be a matter of how to catch up. I'll leave the math up to you.
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grabiner
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Re: Take tax hit to move to lower cost fund?

Post by grabiner »

There is a discussion and a link to a spreadsheet on the wiki:

Paying a tax cost to switch funds

Your combined capital-gains tax rate is not 33%, but 28%, because you can deduct your CA tax against your federal tax at 39.6%; however, it probably goes back up to 32% because of the 3.8% Medicare tax surcharge from the Affordable Care Act. Thus you would lose 16% if you sell.

The difference between the returns of the two funds is only 0.29% after tax

With those assumptions (starting with $10,000 in BSPAX with a $5000 basis, or $8400 in VOO with an $8400 basis), and an 8% return before expenses for both funds, the spreadsheet says that it will take 75 years for switching to be worthwhile. With a 5% return before expenses, it took 61 years. In addition, this assumes that you sell the funds; if you are in a high tax bracket, you might be able to avoid the tax on BSPAX forever if you don't need the money for your own retirement, leaving it to your heirs (who can sell with no capital gain) or donating it to charity.

Therefore, it's likely that you don't want to switch between this pair of funds. Use the BSPAX to make charitable contributions, and don't reinvest dividends.
Wiki David Grabiner
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