Switching from Target Fund to 3 Fund Portfolio - Tax Implications

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bluejay23
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Joined: Mon Mar 11, 2019 12:03 pm

Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by bluejay23 » Mon Mar 11, 2019 12:11 pm

Hi all - I have historically always invested 100% of my savings (both taxable and non-taxable 401k) in a target retirement fund. However, I read recently that the reason some of these funds don't invest in Admiral shares (for lower expense ratio) is because the people who use these funds tend to have smaller accounts. I am not sure what is considered "small" to Vanguard, but I have a lot saved, so I am wondering if I should switch to a 3 fund portfolio that I rebalance myself to get the lower expense ratio. I am just concerned about the tax implications on my taxable account if I sell my target fund to switch over to the 3 fund portfolio, since I have a good amount saved and am also in a high tax bracket. Should I leave my current assets where they are and just start the 3 fund portfolio with any new savings?

DarkHelmetII
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by DarkHelmetII » Mon Mar 11, 2019 1:44 pm

My 2 cents on actions to take:

1) Look at your risk tolerance, investing goals etc... and define your desired mix of equities and bonds. There are additional wrinkles such as how much international equities, large vs. mid / small cap, should I include international bonds etc... But for purposes of conversation let's focus on the key decision of equities vs. bonds.

2) Setup up all dividends within taxable account, from both equities and bonds, to fund a low-cost tax-efficient equity fund such as Vanguard S&P 500.

3a) Rebalance within 401k to achieve desired asset allocation, generally holding bonds in the 401k due to the otherwise tax inefficiency of bonds. Do this in conjunction with 3b.

3b) Consider selling taxable holding of target date fund to purchase a low-cost tax-efficient equity fund such as Vanguard S&P 500, will have to pay taxes on those cap gains eventually anyway. And as years pass, more will be in less tax-efficient bonds. Do this in conjunction with 3a.

Could probably be more prescriptive with additional details such as age, current amounts in 401k vs. taxable, future contribution amounts (in foreseeable years) to 401k vs. taxable, but the above steps nonetheless are perhaps a starting point to consider formulating a plan.

ExitStageLeft
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by ExitStageLeft » Mon Mar 11, 2019 1:47 pm

Welcome to the forum!

I would first turn off automatic re-investment in the taxable account. Next, see what the basis is for the TD fund and what it will cost to liquidate. If you purchased over time, you will have several lots all with a differing basis. See if there are any you can sell now for relatively little capital gains.

Going forward, I would shift to a three-fund portfolio straight away in the tax-advantaged accounts (IRA, 401k). If the opportunity arises to convert the TD fund to a total stock market fund in taxable then do that when the taxes are manageable. There's no point in incurring a big tax hit just to switch over to a three-fund portfolio.

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vineviz
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by vineviz » Mon Mar 11, 2019 1:55 pm

bluejay23 wrote:
Mon Mar 11, 2019 12:11 pm
Hi all - I have historically always invested 100% of my savings (both taxable and non-taxable 401k) in a target retirement fund. However, I read recently that the reason some of these funds don't invest in Admiral shares (for lower expense ratio) is because the people who use these funds tend to have smaller accounts. I am not sure what is considered "small" to Vanguard, but I have a lot saved, so I am wondering if I should switch to a 3 fund portfolio that I rebalance myself to get the lower expense ratio. I am just concerned about the tax implications on my taxable account if I sell my target fund to switch over to the 3 fund portfolio, since I have a good amount saved and am also in a high tax bracket. Should I leave my current assets where they are and just start the 3 fund portfolio with any new savings?
Vanguard's target date funds have very low expense ratios already, and I'm very confident that you'll see their expenses drop dramatically this year and possibly in the next month or two. Vanguard closed the Investor class of most funds late last year and said they'd convert existing holders (including, one presumes, the Target Retirement Funds) to Admiral class shares this year.

I'd be very surprised if you don't see your Target Retirement funds have their expense ratio cut in half this year without you doing anything.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

jyoung
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by jyoung » Mon Mar 11, 2019 8:01 pm

I think there may be good reasons to make this move (more tailored allocation, asset location for tax planning), but I really don't believe ER alone is necessarily a good one. I used to break it out myself and do something similar, but after doing it for a while it began to lose it's luster for me and I found myself getting tempted to tweak things since I was looking at more often.

Then after figuring out the weighted average for admiral shares was saving me about .06-.07 percent, and multiplying 0.0007 with a much larger number than my portfolio balance, I realized that it really didn't matter and switched back to the TDF. I have to manually allocate my 401K since there is no TDF option and that's enough to keep me entertained. Now my IRA's can compound without me ever having to check in on them and slowly destroy them!

Like vineviz said... I too would not be surprised if the ER for target date funds drops in the future, but I just don't see it making that big of a difference, especially for the convenience factor! Much better than a 0.30% - 2% AUM fee for rebalancing.. and for the record I'm pretty "frugal" by most people's standards.

Just my 2cents.

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bluejay23
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by bluejay23 » Wed Mar 13, 2019 5:29 pm

Thanks for all the really good advice! Just out of curiosity...those who mentioned the Vanguard ER might be dropping...where do you get your intel?

radiowave
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by radiowave » Wed Mar 13, 2019 5:41 pm

OP, one other thing to consider in the long run is that target date funds produce dividends from the bond portion of the fund which is taxed at your regular tax rate. See: https://www.bogleheads.org/wiki/Tax-eff ... placement . A portfolio that has domestic and international stock funds in taxable accounts and bonds in tax-deferred accounts tend to be more tax efficient.
Bogleheads Wiki: https://www.bogleheads.org/wiki/Main_Page

jyoung
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by jyoung » Wed Mar 13, 2019 5:56 pm

I personally don't know if they are going to or not, but there is a lot of competition and downward pressure on fees right now so it wouldn't surprise me if they did. ER is important but at some point it's like endless chasing the best savings account rate at banks. I think getting a good rate for a product through a company you like and trust is more important than a difference that amounts to a rounding error. But a dollar is a dollar and if it's that important to someone I would recommend them check out Fidelity's zero funds, going to be hard to beat those on fees!

But I do agree that taxes may be a very good reason to reallocate across account types.

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vineviz
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Re: Switching from Target Fund to 3 Fund Portfolio - Tax Implications

Post by vineviz » Wed Mar 13, 2019 6:09 pm

bluejay23 wrote:
Wed Mar 13, 2019 5:29 pm
Thanks for all the really good advice! Just out of curiosity...those who mentioned the Vanguard ER might be dropping...where do you get your intel?
I was really reading between the lines: the SEC has odd (IMHO) rules around funds-of-funds, and given those rules the only way that Vanguard could reduce the fees on its Target Date and LifeStrategy funds is to do what it did. Namely, consolidate the mutual funds share classes into one.

Furthermore, the only thing the consolidation accomplishes that couldn't be accomplished another (easier) way to to reduce the ER of the Target Date and LifeStrategy funds.

All the details were in the press release,.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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