The High Cost Of Index Funds (for me)

[EyeYield]

I've been a buy and hold investor for 50 years, with most of my significant contributions done between the late '70's and late 90's.
In order for me to simplify my life in retirement, indexing looks very attractive and the education I've received from reading the likes of Bogle, Bernstein and Malkiel prove beyond reasonable doubt that it's a superior investment choice.

But is it worth it for me?

In order for me to go all index funds, I'd have to sell all my holdings and pay long term gains tax on everything, some holdings going back to the 60's; I have no losers to tax harvest. A conservative estimate would be about 100k owed in taxes, but it may be substantially higher.

I plan to do this little by little over the next decade, to blunt the hit, but is there something else I should be considering that I may be missing?

I seem to be stuck between staying the course and indexing.

What would Mr. Bogle recommend??

[livesoft]

Donate everything to charity.

Stop any and all automatic reinvestment of distributions to old funds.

[NYBoglehead]

Since they are in taxable accounts, I agree with livesoft about not re-investing any of the dividends. Instead take the dividends in cash or have them directed to index funds. It's a little tough to give you informed advice without more details about your financial situation. The amount you have in tax-advantaged accounts and other elements of your financial picture would need to be taken into account so that you can get the best advice.

Owing 100k on your gains means that you have substantial gains. It might not hurt as much as you think if you sold.

[bogle2013]

How many stocks are you invested in? just a few or a big basket?

[fatmike91]

Holding heavily appreciated stock in a taxable account is tax efficient -- up until when it isn't (when you sell).


I struggle with similar things. I have no Boglehead advise here (I wrote some covered calls today on an oversized single company stock position...).


/

[Toons]

50 years ,bravo to you,,,,stay the course why change horses mid-stream,take div and capgains and reallocate

[Easy Rhino]

are you retired? Do you have substantial income from other sources? (ira distributions, pensions, etc)

cap gains rate is zero as long as you stay within the 15% tax bracket, so it may at least be worth selling up to that point.

[kaneohe]

are you retired? Do you have substantial income from other sources? (ira distributions, pensions, etc)

cap gains rate is zero as long as you stay within the 15% tax bracket, so it may at least be worth selling up to that point.

.........and be sure that you check this out w/ tax software or tax calculator before doing anything. Numbers mean a lot more than words when taxes are involved since it is easy to misunderstand what words mean.

[cherijoh]

It may seem counterintuitive - but if you do have a low enough taxable income, take advantage by selling when the market dips. I did this when the market tanked a few years ago to move from no-load, but actively-managed mutual funds to index funds. These funds, at their peaks, had considerable embedded capital gains - similar to your current situation. But the embedded capital gains had shrunk considerably when I sold them.

I was in school for an MS and working only part-time, so my taxable income was pretty low before the mutual fund sale. On a day when the market was down considerably, I placed a sell order in an actively managed fund while simultaneously using money from my MM (emergency fund) to buy shares of the TSM index. The proceeds from the sale replenished the MM fund a few days later. (This way I didn't have to worry about being out of the market during a volatile period). I had to guess the amount to invest in TSM, but I came pretty close to having the same amount invested before and after the sale.

The market has since recovered, but now I don't have to worry about unexpectedly large capital gains distributions in December.

FYI - That year my state taxes (which do NOT include favorable cap gains treatment) was higher than my Federal taxes!

[gwrvmd]

Eye Yield: I have also been a buy and hold investor for over 40 years. If your taxable investments are in mutual funds then you have paid taxes on dividends and capital gains every year so you have no capital gains except for the current year that you haven't paid taxes for. Currently your only capital gains are from Jan 1 2013 to today....Gordon

[Postmon]

I was in a similar situation and converted everything over to index funds. I debated for about a year and then finally bit the bullet. I compared the cap gains tax of the active portfolio to the future savings in annual expenses. The break-even point was within a few years so it was worth it for me.

[Postmon]

you have no capital gains except for the current year that you haven't paid taxes for. Currently your only capital gains are from Jan 1 2013 to today

He'd still need to pay long term cap gains tax on the difference between his sell price and his cost basis.

[grabiner]

Wiki article link: Paying a tax cost to switch funds

It's likely to be worth switching unless the current active funds are low-expense and low-turnover, or you are likely to avoid all taxes on the funds by leaving them to your heirs or donating them to charity fairly soon.

If you estimate $100K in taxes, this implies $700K in capital gains. Unless you hit some other income-tax threshold or phaseout, the sale should be split over multiple years so that you sell to the top of the 35% regular tax bracket each year, and pay only 15% (plus 3.8% ACA tax) rather than 20% (plus 3.8%) on the gains.

[dbr]

Eye Yield: I have also been a buy and hold investor for over 40 years. If your taxable investments are in mutual funds then you have paid taxes on dividends and capital gains every year so you have no capital gains except for the current year that you haven't paid taxes for. Currently your only capital gains are from Jan 1 2013 to today....Gordon

I am going to repeat postmon's important post so that no one goes away without realizing that the statement above is partly incorrect.

The investor has already paid tax on dividends and capital gains distributions. The investor will not have paid capital gains tax on increase in value of the holdings after distributions. You still have to track your basis and account for sales that gain or lose from there. It is also a tax mistake to reinvest distributions and not track the increased basis, which will indeed have the effect of reducing the apparent tax cost on sale.

[ResNullius]

As others have said, I think it's important to keep your cap gain tax rate (and dividends too) at the 15% or lower, even if it means taking a few years to totally complete the move. If you have questions about taxes, you might want to consult a tax person for advice. $700K in cap gains suggests a fairly large portfolio. It's worth getting it into index funds, but it's also worth paying close attention to taxes along the way. Good luck.

[MN Finance]

Agreed that it partly depends on the portfolio and your current risk to"non" index and low cost investments. It also depends if you will ever be liquidating the existing funds for income and where the money goes when you die. That said, chances are low cap gains rates will be less in the future, so this is as good a time as any.

[Cyclone]

I read a long time ago that if you own stocks, you can sometimes trade them into a mutual fund for shares in that fund, and it is not a taxable event. It would probably depend on the type of stocks you own and the type of mutual fund in which you want to invest.

[MN Finance]

I read a long time ago that if you own stocks, you can sometimes trade them into a mutual fund for shares in that fund, and it is not a taxable event. It would probably depend on the type of stocks you own and the type of mutual fund in which you want to invest.

That is not relevant to this situation. There are pooled products that exist for high net worth / highly concentrated positions that avoid gains but create diversification. Think if the CEOs of 100 large companies each had 1M each in their own co stock - they could pool it together in an exchange without selling and achieve diversification, of course for a price. That isn't an option for someone holding 250k in XOM, for ex.

[Cyclone]

Maybe my answer wasn't clear. My understanding was that if someone owns shares of XOM, to use an example, they may be able to trade it for shares of a mutual fund that owns XOM. They get diversification without triggering any taxes. But that was a long time ago that I read it, and I wouldn't be able to remember where.

[EyeYield]

Thanks everybody, a lot of food for thought. Since it's almost tax time, I'm going to have a long talk with my accountant.

A little bit more info as requested. I think I'm retired, but I could continue to work if I invested a substantial amount in upgrading my studio, which may end up as a break even proposition.

I have about 26 individual stocks and about 13 funds. I now have all my interest and dividends deposited in a cash account and can live off them. I have no other source of income, except some royalties from tv shows (minor), which will eventually dry up and some EE bonds which will reach final maturity from 2016 to 2027 - also fairly minor - starting at $5000 to about $15000 per year. I plan on starting SS at 70.

I started out with DRIP's in the '60's and was taught (by my thrifty mother) to diversify in the sectors of the S&P 500. I developed an acronym for the sectors M-U-S-I-C - T-H-E-F-T (an unfortunate acronym for someone who worked in the music biz) and once I got one of each, I started over trying to diversify within each sector and added a REIT along the way. Most of my funds are muni or gov bonds, with a small portion of various funds in an IRA. 90% is in taxable. For some random reason, this has worked out well. I've rarely speculated and was never intrigued by the flavor of the decade. In retrospect, I think Mr. Bogle would have really liked my mom and the way she taught me, way back before index funds existed.

Last year I cashed a portion of my drip's in (FIFO), but tried to keep the amounts low to avoid too much tax, but when I transferred my full service account to my discount account, I learned that two large muni funds would not transfer, forcing them to be liquidated. This gave me unexpected capital gains, but I have no idea of the actual tax consequences. Again, I must talk to my CPA.

Being single and with all my family in better shape than I am, I simply have a TOD to my only sibling to avoid probate. I'm interested, eventually, in a SPIA or some sort of long term care policy, but really feel too young (61) at this time.

My main fear is the cost of end of life health care. With no kids, I'm going to most likely be at the mercy of live in assistance or nursing home care givers. Scary!

I think the best thing to do, is to move gradually into indexing, over several years as grabiner suggests. This will require some additional planning and the discipline to avoid analysis paralysis, but I can't see liquidating everything all at once. The switch to index funds will probably be funded from stock sales, not from other funds, for the most part.

I hope I answered all the questions, and thanks again for all the advice.

[grabiner]

I have about 26 individual stocks

I started out with DRIP's in the '60's and was taught (by my thrifty mother) to diversify in the sectors of the S&P 500. I developed an acronym for the sectors M-U-S-I-C - T-H-E-F-T (an unfortunate acronym for someone who worked in the music biz) and once I got one of each, I started over trying to diversify within each sector and added a REIT along the way...

Except for the REIT, you don't need to sell the individual stocks; buying and holding a well-diversified group of 26 individual stocks will behave like a large-cap index fund, costs nothing to maintain, and will be just as tax-efficient as an index fund. (You may need to sell some of your stock holdings if this would give you too much in large-cap US stocks, or if any one stock is so large that it is more than 5% of your portfolio.)

Bond funds shouldn't have too much in capital gains if you need to switch them.