Unwinding long term investments

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iamone
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Unwinding long term investments

Post by iamone » Tue Sep 11, 2018 12:33 pm

I am in the process of moving to passive index funds while avoiding tax consequences. If I total it up using morningstar, I hold 65% in domestic stocks, 11% international and 24% cash or bond equivalents (mostly stable value funds or short term bonds). Although this looks reasonable on paper, there are a couple of active funds in the taxable portion of my portfolio (VHCAX and VPMAX) which together consist 14% of my overall portfolio.

I have held these since 2003 and they generate about 4.5% in long term capital gains, dividends etc. on a yearly basis which have been reinvested. Overall, I have about 60% unrealized gains (mostly long term). Although these are better quality active index funds and haven't failed me so far, I want to gradually reduce their impact on the portfolio while not incurring tax consequences. I can (a) turn off the automated investment (looks like I need to talk to a vanguard rep?) and (b) get the 15% LTCG rate if I do the sale gradually over a period of 3-4 years.

I am sure some of you guys have these or other active funds and in a similar situation. How do you guys handle this? Any other considerations?

delamer
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Re: Unwinding long term investments

Post by delamer » Tue Sep 11, 2018 2:05 pm

I had a similar situation with an inherited taxable portfolio.

You are taking a sensible approach to moving toward your desired portfolio.

If you have any individual positions with capital losses, you can use them to offset gains in other positions. I’d also suggest getting rid of smaller positions first, just for clarity/simplicity.

blackburnian
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Re: Unwinding long term investments

Post by blackburnian » Tue Sep 11, 2018 2:34 pm

You can turn off automated reinvestment online. In your Vanguard account home page, go to "more account information," "trading profile," "account dividend and capital gains election," and choose "transfer to settlement fund."

iamone
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Re: Unwinding long term investments

Post by iamone » Wed Sep 12, 2018 8:30 am

Thanks for the input. I calculated the loss / gain in moving to passive index funds (if the active ones continue to perform at the same level). Can some one validate these numbers?

Start: Assume 40% cost basis (i.e., 60% is profit)
Scenario A: sell @ 15% LTCG and then reinvest immediately in VTI. Assume returns are same and the eventual LTCG when withdrawn is also 15%
After immediate sale and reinvestment in VTI, 1 dollar becomes .4 + .6*.85 = .91
if additional 25% gain at eventual withdrawal, then .91*(1 + .25*.85) = 1.103
if additional 50% gain at eventual withdrawal, then .91*(1+.5*.85) = 1.297
if additional 100% gain at eventual withdrawal, then .91*(1+1*.85) = 1.684

Scenario B: Hold active index funds for now and sell at the end. Assume returns are same as VTI and LTCG remains at 15%.
if additional 25% gain at eventual withdrawal, then 1 dollar becomes .4 + (1.25 - .4)*.85 = 1.123
if additional 50% gain at eventual withdrawal, then 1 dollar becomes .4 + (1.5 - .4)*.85 = 1.335
if additional 100% gain at eventual withdrawal, then 1 dollar becomes .4 + (2 - .4)*.85 = 1.76

So, potential loss (all else being equal) would range from 2% to 5% depending on amount of appreciation from now to eventual withdrawal. Obviously the benefit is better diversification. This seems to indicate a slow approach for conversion selling the lots with the least profit first.

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grabiner
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Re: Unwinding long term investments

Post by grabiner » Wed Sep 12, 2018 7:35 pm

iamone wrote:
Wed Sep 12, 2018 8:30 am
Thanks for the input. I calculated the loss / gain in moving to passive index funds (if the active ones continue to perform at the same level). Can some one validate these numbers?

Start: Assume 40% cost basis (i.e., 60% is profit)
Scenario A: sell @ 15% LTCG and then reinvest immediately in VTI. Assume returns are same and the eventual LTCG when withdrawn is also 15%
After immediate sale and reinvestment in VTI, 1 dollar becomes .4 + .6*.85 = .91
if additional 25% gain at eventual withdrawal, then .91*(1 + .25*.85) = 1.103
if additional 50% gain at eventual withdrawal, then .91*(1+.5*.85) = 1.297
if additional 100% gain at eventual withdrawal, then .91*(1+1*.85) = 1.684

Scenario B: Hold active index funds for now and sell at the end. Assume returns are same as VTI and LTCG remains at 15%.
if additional 25% gain at eventual withdrawal, then 1 dollar becomes .4 + (1.25 - .4)*.85 = 1.123
if additional 50% gain at eventual withdrawal, then 1 dollar becomes .4 + (1.5 - .4)*.85 = 1.335
if additional 100% gain at eventual withdrawal, then 1 dollar becomes .4 + (2 - .4)*.85 = 1.76
What you miss here is that the active funds are expected to underperform the index funds after tax; they will generate taxable capital gains. By switching to index funds, you delay the tax on those gains, and pay the tax at a lower rate if some of the gains are short-term. You may also benefit from lower expenses on the index funds, although it isn't much of a difference since they are also with Vanguard.

The wiki has a link to a spreadsheet at which you can estimate the difference: Paying a tax cost to switch funds Usually, it's better to switch the whole thing.

Another use of the active funds is to donate them to charity. Don't do this just for the tax benefit, but if you want to make large donations to charity, using the funds allows you to avoid the capital-gains tax.
Wiki David Grabiner

iamone
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Re: Unwinding long term investments

Post by iamone » Wed Sep 12, 2018 11:45 pm

grabiner wrote:
Wed Sep 12, 2018 7:35 pm
What you miss here is that the active funds are expected to underperform the index funds after tax; they will generate taxable capital gains. By switching to index funds, you delay the tax on those gains, and pay the tax at a lower rate if some of the gains are short-term. You may also benefit from lower expenses on the index funds, although it isn't much of a difference since they are also with Vanguard.

The wiki has a link to a spreadsheet at which you can estimate the difference: Paying a tax cost to switch funds Usually, it's better to switch the whole thing.

Another use of the active funds is to donate them to charity. Don't do this just for the tax benefit, but if you want to make large donations to charity, using the funds allows you to avoid the capital-gains tax.
I agree with your statement in general about active vs passive funds. These particular 2 funds seem to keep up with VTI quiet well. Well, atleast over the last 15 years that I tracked them. The expense ratios are reasonable. However, I agree that there is a definite diversity risk as they are focused on certain hand picked sectors. I didn't know about the charity / capital gains angle. Thanks for that input.

MikeG62
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Re: Unwinding long term investments

Post by MikeG62 » Thu Sep 13, 2018 7:16 am

iamone wrote:
Tue Sep 11, 2018 12:33 pm

...I am sure some of you guys have these or other active funds and in a similar situation. How do you guys handle this? Any other considerations?
It is a tough one - and a good example for those reading this thread and investing in their taxable accounts as to why they should carefully consider the LT implications of using actively managed MF's in a taxable account (setting aside the extremely compelling reasons to just index in the first place).

FWIW, I have one remaining legacy actively managed MF in my taxable account with a large unrecognized LTCG. Although I did sell another actively managed MF (in full) last year (was sick of the taxable distributions the fund was dumping on me) I am loathe to sell the remaining position because of the tax implication. While one should generally not allow the tax tail to wag the dog, this is easier said than done. In hindsight, I wish I had never purchased these funds, even though they did (have done) just fine in comparison to their benchmarks during the period I have owned them.

When I set up our DAF, I used some highly appreciate positions in one of those MF's to fund that account (twice now). However, by no means did that take care of meaningful percentage of the actively managed positions.

I think you did an interesting job of laying out the comparison between your two options.
Real Knowledge Comes Only From Experience

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