sell fidelity index mutual fund and replace with etf index for tax benefit?

[blastoff]

I am purposely sparing all details as I think I have a simple and more focused question for which they are not necessary. I know my question has been loosely answered here before in other posts, and also touched on in the wiki,.... I just want to make sure there is nothing I am missing (read: hand-holding).

I currently hold Fidelity Total Market Index (FSTVX), International Index (FSGDX), and Emerging Markets Index (FPMAX) in a taxable account. I also have US index bond fund. These are all Fidelity Index Mutual Funds.

The Fidelity Total Market index throws off a considerable amount of capital gain distributions each year. This is undesirable for me for tax purposes.

For reasons that I am already done the math on and have concluded are worth doing, I plan to realize some gains and sell a portion of the Total Market FSTVX mutual fund before the end of the year. Is there any reason to not replace it with the ITOT total market commission free index when I "re-purchase"?

As far as I can tell:
The downside is simply having more clutter in my account with more symbols.
The benefit is that it is more tax efficient for me to have ITOT as I am not forced to have capital gain distributions each year.

Is there anything I am missing or others reason to not exchange FSTVX for ITOT? (up to the amount it makes sense for me to sell FSTVX)

Thanks!

[livesoft]

I don't have a problem with that. Presumably, you are happy to realize capital gains from selling FSTVX, but I hope the gains are long-term for the reduced tax rate or you have losses to offset those gains.

You can set your other funds to not reinvest dividends, too, so that you manually reinvest them. And don't forget to have the Cost Basis Method set to Specific Identification.

[Artsdoctor]

I am purposely sparing all details as I think I have a simple and more focused question for which they are not necessary. I know my question has been loosely answered here before in other posts, and also touched on in the wiki,.... I just want to make sure there is nothing I am missing (read: hand-holding).

I currently hold Fidelity Total Market Index (FSTVX), International Index (FSGDX), and Emerging Markets Index (FPMAX) in a taxable account. I also have US index bond fund. These are all Fidelity Index Mutual Funds.

The Fidelity Total Market index throws off a considerable amount of capital gain distributions each year. This is undesirable for me for tax purposes.

For reasons that I am already done the math on and have concluded are worth doing, I plan to realize some gains and sell a portion of the Total Market FSTVX mutual fund before the end of the year. Is there any reason to not replace it with the ITOT total market commission free index when I "re-purchase"?

As far as I can tell:
The downside is simply having more clutter in my account with more symbols.
The benefit is that it is more tax efficient for me to have ITOT as I am not forced to have capital gain distributions each year.

Is there anything I am missing or others reason to not exchange FSTVX for ITOT? (up to the amount it makes sense for me to sell FSTVX)

Thanks!

I don't think I'd characterize the non-qualified dividends and capital gains distributions generated from FSTVX as "considerable" although I agree that if you're dealing with large sums, those declarations are annoying. Unless you have capital losses to offset the gains, I wouldn't feel compelled to sell FSTVX with significant short-term gains. If you're generating long-term gains, ITOT is a great idea.

[CABob]

Why does FSTVX have such high capital gains distributions while ITOT and Vanguard's VTSMX not have them?

[beehappy]

Would Fidelity permit an exchange to ITOT like Vanguard does? That'd address the tax issue if permitted.

[blastoff]

I don't have a problem with that. Presumably, you are happy to realize capital gains from selling FSTVX, but I hope the gains are long-term for the reduced tax rate or you have losses to offset those gains.

You can set your other funds to not reinvest dividends, too, so that you manually reinvest them. And don't forget to have the Cost Basis Method set to Specific Identification.

Thanks for reply.

Gains are long-term. I am at the border 15%/25% bracket and have been tax-gain harvesting, but that will change soon. I also have a pending move for a job in a state with higher capital gains taxes, so I don't mind realizing some gains now as doing so next year will be more costly. I also am playing to effectively convert taxable money to retirement tax protected money. I don't make enough to max out retirement space and live a fairly frugal life, but my taxable accounts are larger than I need them to be.

I don't reinvest dividends. I also recently changed cost basis to specific identification. Previously it did not matter in practice to me, but accounts are bigger now so it does.

[blastoff]

Why does FSTVX have such high capital gains distributions while ITOT and Vanguard's VTSMX not have them?

My understanding is vanguard has a unique ETF like wrapper they put around mutual funds for favorable tax treatment.

[wrongfunds]

I am not seeing vast difference between corresponding funds FSTVX vs VTSAX
Fidelity® Total Market Index Fund - Premium Class vs Vanguard Total Stock Market Index Fund Admiral

I see about $1.50 vs $1.20 and both have comparable NAV.

Am I wrong in my guesstimate?

[Artsdoctor]

I am not seeing vast difference between corresponding funds FSTVX vs VTSAX
Fidelity® Total Market Index Fund - Premium Class vs Vanguard Total Stock Market Index Fund Admiral

I see about $1.50 vs $1.20 and both have comparable NAV.

Am I wrong in my guesstimate?

No, you're correct. There is very little difference. However, there is enough of a difference that I would not personally hold my total market fund at Fidelity.

This will all come down to asset location. If your assets are mostly in tax-advantaged accounts, this will not matter.

A sizeable chunk of investors will have sizeable taxable accounts. It would not be a stretch to imagine fixed income being held mostly in tax-deferred accounts and equity index funds in a taxable account. Since a total stock market index fund will be the workhorse of most investors' portfolios, you may wind up with some very large balances in such a fund going into retirement. Therefore, even small tax inefficiencies (such as noted in FSTVX) can result in needless taxes which will not break you, but are annoying.

It's safe to say that most total market index funds are very, very similar. Therefore, you may as well go with the very best in tax efficiency since you're going to conceivably hold the fund for decades.

[Earl Lemongrab]

Would Fidelity permit an exchange to ITOT like Vanguard does? That'd address the tax issue if permitted.

No. For one thing, ITOT is an iShares product from Blackrock, not Fidelity. Secondly the only reason Vanguard can do the no-gains conversion is because the ETFs are share classes of the mutual funds and Vanguard has that patented.

[oldcomputerguy]

Would Fidelity permit an exchange to ITOT like Vanguard does? That'd address the tax issue if permitted.

Vanguard's equivalency of mutual and exchange-traded fund classes is patented, so no, Fidelity can't do that. There would have to be a sale followed by a purchase, which would involve realizing capital gains on FSTVX shares.

[ddd]

Yes, FSTVX is not as tax efficient as ITOT. What's not clear to me is that, if one comes ahead of the other when you sell them, why does it matter?

For example, according to Fidelity, the average annual returns after taxes on distributions and sale of fund shares are:

1Y 3Y 5Y 10Y
FSTVX 10.92% 8.21% 11.26% 6.09%
ITOT_ 10.45% 7.94% 10.89% 5.60%

Do these numbers not account for the taxes you paid over the years prior to the sale?

Of course, it's a different story if the distributions push you to a different tax bracket

[grabiner]

Yes, FSTVX is not as tax efficient as ITOT. What's not clear to me is that, if one comes ahead of the other when you sell them, why does it matter?

For example, according to Fidelity, the average annual returns after taxes on distributions and sale of fund shares are:

1Y 3Y 5Y 10Y
FSTVX 10.92% 8.21% 11.26% 6.09%
ITOT_ 10.45% 7.94% 10.89% 5.60%

I suspect that Fidelity doesn't know about qualified dividends for ITOT. The two funds have almost identical pre-tax returns, so their after-tax returns should be fairly close, with ITOT having slightly higher returns over the longer terms because of the capital gains. (Morningstar may make the opposite error; it reports higher tax costs for the Fidelity fund, which may imply that it is treating some Fidelity dividends as non-qualified.)

[blastoff]

Could someone simplify this one more level and dumb.it down? I do my own taxes, understand well capital gains and quality dividend rates, etc, but 100% sure I follow FSTVX vs ITOT comparison.

"I suspect that Fidelity doesn't know about qualified dividends for ITOT. ". What does that mean?

I guess my more general question is that I'm not looking to just choose the one that had the higher return over some certain time. But, if one consistently had higher returns that are not due to random chance but rather an identifiable and structural difference then that might be important when deciding what to choose.

[grabiner]

Could someone simplify this one more level and dumb.it down? I do my own taxes, understand well capital gains and quality dividend rates, etc, but 100% sure I follow FSTVX vs ITOT comparison.

"I suspect that Fidelity doesn't know about qualified dividends for ITOT. ". What does that mean?

All funds report their pre-tax returns in the same way, as they have a daily report of share price, and distributions when they are made. Therefore, if you check two different sources for pre-tax returns of the same fund over the same period, the returns should be identical. (If they are not, what usually happens is that the period does not match; sometimes, one source will have updated returns for the current day and another has not.)

But to calculate after-tax returns, you need to know the tax status of the distributions. The fund provider (such as Fidelity for a Fidelity fund) knows how much of each dividend was qualified, and thus taxed at a lower rate. Third parties (such as Morningstar, or Fidelity for a non-Fidelity fund, which may use Morningstar's data) may not know whether dividends were qualified, and thus assume that the entire dividend is taxed at your full rate.

This is a common issue using Morningstar to evaluate Vanguard funds. Most Vanguard index funds have ETF and Admiral share classes with the same expenses. Since these are share classes of the same fund, the distributions are the same percentage of the fund value, and the same percentage is qualified. But depending on how Morningstar got the data, it may not know how much of the dividend is qualified, and thus may report different after-tax returns for the two share classes. Vanguard's reported after-tax returns for the two share classes will be identical

I guess my more general question is that I'm not looking to just choose the one that had the higher return over some certain time. But, if one consistently had higher returns that are not due to random chance but rather an identifiable and structural difference then that might be important when deciding what to choose.

This is the right way to think about the decision. Past performance is not an indication of future results. However, past tax behavior is a good indication of future tax behavior: funds which have non-qualified dividends, or distribute capital gains, are likely to do the same in the future. And expenses are a known factor: two funds tracking similar indexes with different expenses should have different pre-tax returns.

So you should check with the fund provider to see what fraction of the dividends are qualified. For total-market indexes, this should be close to 100%, and won't differ much between funds. Then add the expense ratio, and the tax cost on any capital gain distributions; if a fund distributes 1% of its value annually in capital gains, that is 0.15% extra cost for most taxpayers, or 0.20% if you pay state tax as well.

[blastoff]

Grabiner -

Thanks for taking the time to write an incredibly clear reply.

If my understanding is correct, the reported after-tax returns for ITOT may be worse than they are in reality because the people are reporting the after-tax return may be making worse-case (and likely inaccurate) assumptions. Put more simply, ITOT is probably better to own than FSTVX in a taxable account.

[grabiner]

Grabiner -

Thanks for taking the time to write an incredibly clear reply.

If my understanding is correct, the reported after-tax returns for ITOT may be worse than they are in reality because the people are reporting the after-tax return may be making worse-case (and likely inaccurate) assumptions. Put more simply, ITOT is probably better to own than FSTVX in a taxable account.

This is correct.

In addition, the reported after-tax returns for all funds are based on standard assumptions, which may not match your own tax situation. I believe the standard assumption is that you are in the top federal tax bracket but pay no state tax, so your tax is 39.6% on ordinary income and 20% on qualified dividends and long-term gains. You may get a better estimate based on your own tax situation.

[Artsdoctor]

Blastoff,

It's all about understanding your own tax situation, as best as you can, as noted above. Sometimes, it can be very helpful to use a tax software program to really understand your own situation (putting in $1,000 of extra dividends and see how much it can cost you, for example).

You say that you are holding the US Index Bond Fund, presumably in your taxable account. If so, you're marginal tax rate is probably not extraordinarily high (otherwise, you'd most likely be holding a muni bond fund). If this is correct, teasing out the differences between the Fidelity fund and ITOT may be like dancing on the head of a pin. I'd hate to see you realizing capital gains for little benefit. But this is conjecture and reading between the lines so I may not be interpreting your situation correctly.

[CppCoder]

If I did the math correctly (and I probably messed it up somewhere), if you pay 15% capital gains, then the tax inefficiency of FSTVX was about 9 basis points in 2016. 2016 was an abnormally high capital gains year for FSTVX (or previous years were abnormally low). Personally, I'm at Fidelity, and I use FSTVX in my taxable account. I view the 9 basis points (+/- depending on the year) as a convenience fee because I prefer mutual funds to ETFs. Each investor needs to decide what their priorities are based on their individual circumstances.

[welderwannabe]

In addition, the reported after-tax returns for all funds are based on standard assumptions, which may not match your own tax situation. I believe the standard assumption is that you are in the top federal tax bracket but pay no state tax, so your tax is 39.6% on ordinary income and 20% on qualified dividends and long-term gains. You may get a better estimate based on your own tax situation.

There is also the 3.8% surcharge on investment income. Anyone in the 39.6 bracket is probably going to be paying the 3.8% surcharge.

[blastoff]

If I did the math correctly (and I probably messed it up somewhere), if you pay 15% capital gains, then the tax inefficiency of FSTVX was about 9 basis points in 2016. 2016 was an abnormally high capital gains year for FSTVX (or previous years were abnormally low). Personally, I'm at Fidelity, and I use FSTVX in my taxable account. I view the 9 basis points (+/- depending on the year) as a convenience fee because I prefer mutual funds to ETFs. Each investor needs to decide what their priorities are based on their individual circumstances.

Out of curiosity, why the preference for mutual funds.

I am not chasing an extra $8 in savings.

[CppCoder]

If I did the math correctly (and I probably messed it up somewhere), if you pay 15% capital gains, then the tax inefficiency of FSTVX was about 9 basis points in 2016. 2016 was an abnormally high capital gains year for FSTVX (or previous years were abnormally low). Personally, I'm at Fidelity, and I use FSTVX in my taxable account. I view the 9 basis points (+/- depending on the year) as a convenience fee because I prefer mutual funds to ETFs. Each investor needs to decide what their priorities are based on their individual circumstances.

Out of curiosity, why the preference for mutual funds.

I am not chasing an extra $8 in savings.

I just find mutual funds easier. I invest in my taxable account twice per month, and I prefer just setting my order either the night before or early in the morning before work and forgetting about it. Then, I get the exact NAV price at the end of the trading day. If I were buying ETFs, I'd probably buy them midday with a limit order, which isn't difficult, but I'd have to have a free minute or two to do it on my phone, which I don't always have. I also like that I can buy mutual funds as fractional shares in any dollar amount rather than having to buy whole shares and subsequently leaving cash sitting in my Fidelity account. I acknowledge that my strategy is suboptimal from a tax perspective, but I don't care. My strategy is simple and good enough.