Paying capital gains taxes to switch to index funds

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tj-longterm
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Paying capital gains taxes to switch to index funds

Post by tj-longterm »

Unlike many here, I have a predominantly taxable portfolio. I've managed to switch the majority of my holdings into just a few index funds.

However, around 20% of my portfolio remains legacy actively managed funds, and a couple stocks. All of these have gains of 50% or more, with many in the 100% gain range. In part, I've been holding on to these because I'm reluctant to add on to my tax bill by getting rid of them.

But I wonder if I'm being irrationally worried about capital gains tax. I was doing some Excel calculations to see just how bad it would be.

One Scenario:
Actively managed fund of market value $10,000 with 100% gain. Therefore, I would have to pay $750 in taxes at a 15% tax rate if it were sold.

Assuming the active fund and the index fund have the same pretax expense, and the actively managed fund has a 0.7% higher expense ratio, and ignoring additional tax cost in the actively managed fund (all conservative estimates), it would take just 14 years until one would have benefited from switching to the index fund. In all likelihood, it would be even sooner.

In 30 years, I would have achieved at least an extra 0.4% annual return, regardless of the majority of market conditions.

It seems to me that the only questionable cases are where the expense ratio difference is small (and then it depends on whether the active managed fund can managed to do as well as the index).

Should I therefore bite the tax bullet and get rid of these actively managed funds even though I may have significant capital gains to pay, given that I have many years till I retire?
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snowback96
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Post by snowback96 »

I have struggled with this question too. If you're a long way from retirement, just bite the bullet and switch to index funds. The current 15% rate ain't too bad. It might cost you a chunk of cash up front but at least you don't have to aggravate yourself by watching yourself underperform the indexes year after year.

I switched out a couple active funds earlier this year and figured based on the different expense ratios, it would take 5-10 years to break even. Since then, I have tracked the performance of the indexes I bought versus the actively managed funds I sold and the improved performance has already made up most of my tax bill! I plan to jetison the rest of my active portfolio in January.

I look at the up-front tax costs "tuition" for my investing education. I learned my lesson and now it's time to pay up.
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Mel Lindauer
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Post by Mel Lindauer »

Hi tj:

It looks like you've done the math, so you know your payback periods, so that's a good start.

Another thing to consider is that the current 15% LTCG tax rate is very low compared to the previous rates of 20% and 28%, and that favorable 15% LTCG rate may well change soon.

So, when you combine the two factors, now just might turn our to be the right time to get your portfolio to where you want it to be.

However, if you think that you'll never need to sell these active funds in order to provide for your living expenses, you might decide to leave them to your heirs. They'd then enjoy the stepped-up cost basis which would result in no capital gains taxes ever being due.

Regards,

Mel
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SpringMan
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Post by SpringMan »

You can check your funds here.
http://www.smartmoney.com/fundanalyzer/
After entering your funds, arrow down to Tax Efficiency, 1 is best and 5 is worst. Total Stock Market index and Total International Index only get 2s. I would consider selling based on tax inefficiency only if the fund got a 4 or 5. Of course there are other factors to consider which you can use the same tool to examine.
Best,
Best Wishes, SpringMan
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active in taxable

Post by pkcrafter »

tj, the longer you hold an active fund in taxable the higher the chance that something will go wrong with the fund that forces you sell when you really don't want to. Even the best funds are not immune. Something is going on with Dodge and Cox that is changing how their funds invest. If it can happen to D/C, it can happen to anyone.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.
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Speedy
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Post by Speedy »

Hi TJ:

I went through an exercise like this recently to help my son evaluate switching to index funds, and also placing funds in taxable vs tax deferred accounts.

My suggestion is that a good way to look at the comparison is to look at real long term returns for each fund you are considering selling in a taxable account and compare it to the index fund you would then purchase. The comparison should be made after subracting the tax cost ratio (available on Morningstar) to adjust the returns down in both cases.

Some judgement may need to be applied to select the appropriate time period for tax cost ratio because the down market in the early part of this decade tended to result in lower than realistic tax cost ratios for many active funds.

In my son's portfolio, I found pay off periods in most cases of less than 4 to 5 years, many in just a few years.

I agree with Mel's comment that higher capital gains rates seem quite probable in our future, so taking the capital gains hit now and resetting your portfolio to a higher cost basis may pay off big time if you plan to draw down these assets in retirement.


Regards,

Bill
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grabiner
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Actually, the case for switching is even stronger

Post by grabiner »

tj-longterm wrote:One Scenario:
Actively managed fund of market value $10,000 with 100% gain. Therefore, I would have to pay $750 in taxes at a 15% tax rate if it were sold.

Assuming the active fund and the index fund have the same pretax expense, and the actively managed fund has a 0.7% higher expense ratio, and ignoring additional tax cost in the actively managed fund (all conservative estimates), it would take just 14 years until one would have benefited from switching to the index fund. In all likelihood, it would be even sooner.
In fact, you would be better off after those 14 years, because you would have an equally large portfolio with a higher cost basis ($9250 rather than $5000), so you would have $4250 less in gains if you sold.

And the more important issue with the actively managed fund is its higher tax cost; even a low-cost actively managed fund may cost 1% extra in taxes.

I worked out the numbers in more detail in Morningstar Conversation 48860, so you can make a better estimate of the break-even point.
Pangloss
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LTCG

Post by Pangloss »

Hi TJ.

The question on how to hand holdings like this is a difficult one. My wife owns some stock that was given to her when she was a baby, and I'd love to move it index funds, but I can't stomach the tax hit. (One of the two stocks has also handily outperformed the market of the last several years, which is added discouragement against selling the holdings). I don't know if you make many charitable contributions, but we now make all of ours by donating stock and increasing the contributions to our retirment accounts by how much we would have given to charity. This arrangement allows us shift more money into tax sheltered accounts and to get rid of appreciated holdings without paying any capital gains tax.
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woof755
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Re: Actually, the case for switching is even stronger

Post by woof755 »

grabiner wrote:
tj-longterm wrote:One Scenario:
Actively managed fund of market value $10,000 with 100% gain. Therefore, I would have to pay $750 in taxes at a 15% tax rate if it were sold.

Assuming the active fund and the index fund have the same pretax expense, and the actively managed fund has a 0.7% higher expense ratio, and ignoring additional tax cost in the actively managed fund (all conservative estimates), it would take just 14 years until one would have benefited from switching to the index fund. In all likelihood, it would be even sooner.
In fact, you would be better off after those 14 years, because you would have an equally large portfolio with a higher cost basis ($9250 rather than $5000), so you would have $4250 less in gains if you sold.

And the more important issue with the actively managed fund is its higher tax cost; even a low-cost actively managed fund may cost 1% extra in taxes.

I worked out the numbers in more detail in Morningstar Conversation 48860, so you can make a better estimate of the break-even point.
Would you mind if I asked you a specific question? I followed your link to the M* conversation, but I'm still perplexed.

I have a mutual fund in a taxable account that is worth 28,600 bucks. I have a basis of 8,000 in it. Its expense ratio is 0.6%. I would be moving to Vang TSM, at 0.19%. The tax cost ratio, per morningstar, of my fund is 0.71 over the last 5 years (1.31 over the last 10 years). The tax cost ratio of VTSMX is 0.3 over the last 5 years.

In addition, I pay 5% front load on all dividends being reinvested ($1200 in dividends per year). I do not add any additional contributions to the fund, and haven't for 15 years.

I plan to hold VTSMX for a long time, naturally. Is there a succinct way of telling if this is worth it? or how many years it would take me to recoup the $3000 in capital gains taxes I'd have to pay upon selling?

Online calculators have failed me on this one...I have to consider that the $3,000 that will consequently become the property of Uncle Sam will no longer be earning money for me!

Thanks, grabiner!
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tj-longterm
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Post by tj-longterm »

Thanks everyone for your replies. I think I'll do it, I can't see too much of a reason not to in my case.
Is there a succinct way of telling if this is worth it? or how many years it would take me to recoup the $3000 in capital gains taxes I'd have to pay upon selling? Online calculators have failed me on this one...I have to consider that the $3,000 that will consequently become the property of Uncle Sam will no longer be earning money for me!
I don't know of any succinct way. However, If I put these facts into my excel spreadsheet:
Current market value: $28,600
Cost basis: $8,000
Active expense ratio: 1.31%
Index expense ratio: 0.49%
Capital gains tax rate: 15%
Assume that the pre-expense/tax return on the active fund equals the index fund, then:

It should take on average between 14 and 16 years to recoup the tax paid (the exact amount depends on the annual return). Note that this could also vary significantly if there are very good years in the first couple years, then bad years later on. My model assumes a constant stock market return as I don't have the skills to put in more advanced possibilities.

At 6% constant annual return:
Active Fund Advantage:
Year 0 = $3,090
After 5 years: $2,610
After 10 years: $1,613
After 15 years: ($154)
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woof755
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Post by woof755 »

But the active ER is 0.58 and the index ER is 0.19.

It's the tax-inefficiency that I think is killing me (along with the whole past performance doesn't guarantee future success aspect).
"By singing in harmony from the same page of the same investing hymnal, the Diehards drown out market noise." | | --Jason Zweig, quoted in The Bogleheads' Guide to Investing
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grabiner
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Post by grabiner »

tj-longterm wrote:Thanks everyone for your replies. I think I'll do it, I can't see too much of a reason not to in my case.
Is there a succinct way of telling if this is worth it? or how many years it would take me to recoup the $3000 in capital gains taxes I'd have to pay upon selling? Online calculators have failed me on this one...I have to consider that the $3,000 that will consequently become the property of Uncle Sam will no longer be earning money for me!
I don't know of any succinct way. However, If I put these facts into my excel spreadsheet:
Current market value: $28,600
Cost basis: $8,000
Active expense ratio: 1.31%
Index expense ratio: 0.49%
Capital gains tax rate: 15%
Assume that the pre-expense/tax return on the active fund equals the index fund, then:

It should take on average between 14 and 16 years to recoup the tax paid (the exact amount depends on the annual return). Note that this could also vary significantly if there are very good years in the first couple years, then bad years later on. My model assumes a constant stock market return as I don't have the skills to put in more advanced possibilities.

At 6% constant annual return:
Active Fund Advantage:
Year 0 = $3,090
After 5 years: $2,610
After 10 years: $1,613
After 15 years: ($154)
I don't think you allowed for the difference in taxes upon selling the fund. By paying taxes now and raising your basis from $8000 to $25,510, you reduce the capital gain you would have to pay by $17,510; you also pay capital-gains tax on any difference in the fund values. Thus:

Thus, here are the gains from switching now and selling at the end of the period, versus keeping the active fund and selling it at the end of the period:
Year 0: 0 (you have $3090 less but $20,600 less in capital gains)
Year 5: $408 (you have $2610 less but $20,120 less in capital gains)
Year 10: $1255 (you have $1613 less but $19,123 less in capital gains)
Year 15: $2772 (you have $154 more and $17,456 less in capital gains)

This slightly overstates the advantage of switching, as the higher tax cost on the active fund means that you will have a higher tax basis on your reinvested distributions, but it's close.

(And that front load on dividends is an extra 0.10% expense that you didn't count, assuming a 2% yield.)
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Post by Speedy »

Aaron:

I have a few thoughts on your question:

1. Have you considered the dividends as being added to your cost basis? A common error is to consider only the original cost of the investment. If you make a formal request, the brokerage should provide you with the cost basis considering cost of re-invested dividends and front end loads.

2. You can probably stop reinvesting dividends and instead invest those dividends in an index fund. This would seem to make a lot of sense especially with the big front end load you are paying.

3. Look at the ten year returns of your load fund after accounting for the front end load paid on the dividends (and most likely the initial investment). The prospectus of the fund should have after tax 10 year returns after paying the load and selling the shares. Compare this number to the same number for the index fund you would buy. The annual return difference in percent will be X%. Divide the capital gains rate by X, and that will give you a good approximation of the number of years to break even. If X = 3, and your capital gains rate is 15%, then it would take 5 years to break even on doing the switch. After that it's all gravy.

If you want me to take a swing at analyzing it, let me know the ticker symbol for your load fund. Regards,

Bill
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tj-longterm
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Post by tj-longterm »

woof755 wrote:But the active ER is 0.58 and the index ER is 0.19.

It's the tax-inefficiency that I think is killing me (along with the whole past performance doesn't guarantee future success aspect).
I was adding the tax cost ratio to the ER. My understanding was that the tax cost ratio was the approximate equivalent "expense ratio" due to the tax inefficiency of the fund. (This could be wrong)
grabiner wrote: I don't think you allowed for the difference in taxes upon selling the fund. By paying taxes now and raising your basis from $8000 to $25,510, you reduce the capital gain you would have to pay by $17,510; you also pay capital-gains tax on any difference in the fund values.
I didn't even think of that. If the fund will be sold to pay for your retirement, that makes switching now an even better deal!

However, if you plan to pass the fund on to your children (which mel brought up), then the new stepped up basis doesn't matter and you should only consider the actual values of the funds not the after-tax values of the funds. Even here, it seems better to switch to the index fund if there is sufficient time before the funds will be passed to your children.
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Post by theduke »

tj-longterm
If you are in the 15% tax bracket, wait till next year to sell. The capital gains rate will be 0 for 2008, 2009, and 2010 for people in the 15% bracket. 2009 and 2010 has to be considered shaky if/when a new president changes tax policy. Also the capital gains once you sell becomes income so you would have to consider that in your total income to stay in the 15% bracket.
John
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Post by PatrickS »

Excuse my ignorance, but aren't those of of living in states with income tax subject to a federal long term capital gains tax rate of 15% (depending on your bracket) AND a state tax. It's my understanding that (in California) I get taxed at 15% by the fed and at my marginal income tax rate by the state when I sell an asset with LT capital gains.

For Woof755, wouldn't your actual tax bill for the long term gain be the 15% plus your (probably 7%) state income tax rate?
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Mel Lindauer
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Post by Mel Lindauer »

Speedy bring up an important point in his/her reply above, and that's that there have most likely been taxable distributions throughout all the years you've owened the holdings, so your cost basis is actually much higher than you'd get by simply subtracting the intitial investment from today's value.

Remember, you've already paid taxes on the distributions you reinvested, so that adds to your cost basis.

Bottom line: if you overlooked this point, you most likely owe less in taxes than you think.

Regards,

Mel
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Ted Valentine
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Re: LTCG

Post by Ted Valentine »

Pangloss wrote: The question on how to hand holdings like this is a difficult one. ... I'd love to move it index funds, but I can't stomach the tax hit.
Pangloss - this is isn't directed at you, per se, but to the discussion. I love your strategy of giving stock to charity, btw.

My question is why do people look at it this way? Isn't technically the "tax hit" already there? i.e., 15% of the gain on your statement is not yours anyway. It belongs to the Government. It seems to me that you can take that 15% hit NOW or take it the future (and perhaps more than 15% in the future). Doesn't the math come out the same in the end?

1. Take long term CG tax today
1000 growth x 15% = $150
Invest $850 @10% in 10 years you have $2301

2. Delay CG tax for 10 years
1000 growth @ 10% in years you have $2707
Pay 15% tax (may be higher) you have $2301

It seems to me that the only question in the comparison should be which fund is more efficient in its distributions and short term capital gains.

Please correct me if I'm wrong.
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Post by gassert »

Ted -

Finally some comes up with the "right" answer. There is no difference in tax liability if someone sells now or later considering the old and new funds are the same.

And if the new fund is better, then the SOONER the switch is made the better. So waiting only makes it worse.

Also, considering tax rates are so low, it also makes the case for sooner. I sold and reinvested every taxable investment I own over the last year or two becuase I figure 15% is as good as it gets. (Only issue is state tax - if you live in high tax state now and then retire to FL, for ex, then you paid the state tax when you didnt need to)

The ONLY negative issue would be if the investment never would have been sold anyway (ie - gifting or passed to heirs). And ONLY in that case would you want to analyze the ER, tax efficiency, etc to get "break even" numbers.

All that analysis was great - but the simple math just posted is all you need to worry about.
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Re: Actually, the case for switching is even stronger

Post by RustyShackleford »

grabiner wrote: In fact, you would be better off after those 14 years, because you would have an equally large portfolio with a higher cost basis ($9250 rather than $5000), so you would have $4250 less in gains if you sold.
One realization I had recently is that it makes sense to consider
what is the rate-of-return on the money you spent, now, to pay
those capital gains taxes ?

If you take the gains now, you'll pay 15% tax on them (for most
taxpayers). Assuming you're in for the long-term and end up
selling the holding in 30 years, and let's say the LTCG rate is 30%
at that point, well then you've effectively doubled your money in
30 years - a lousy 2.3% annualized return. Any gains over and
above the gains you have today will be taxed at the 30% rate
regardless of whether or not you "reset the basis" now.

Of course, I'm talking about resetting the basis on a holding, selling
it and rebuying it or something similar. If you're doing this to move
into a fund that's better/cheaper (as you say you are) or improves
your asset allocation, then of course that's a big factor too and
probably more important. But I believe it is good not to lose sight
of this issue I bring up - what will my rate of return be on the money
I "invest" if paying capital-gains taxes TODAY ?
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Re: LTCG

Post by alvinsch »

Ted Valentine wrote: My question is why do people look at it this way? Isn't technically the "tax hit" already there? i.e., 15% of the gain on your statement is not yours anyway. It belongs to the Government. It seems to me that you can take that 15% hit NOW or take it the future (and perhaps more than 15% in the future). Doesn't the math come out the same in the end?

1. Take long term CG tax today
1000 growth x 15% = $150
Invest $850 @10% in 10 years you have $2301

2. Delay CG tax for 10 years
1000 growth @ 10% in years you have $2707
Pay 15% tax (may be higher) you have $2301

It seems to me that the only question in the comparison should be which fund is more efficient in its distributions and short term capital gains.

Please correct me if I'm wrong.
That looks wrong to me.

They only result in the same result if the equity currently has no gain (basis = current value). As an example, lets assume the $1000 investment has a $0 basis (all gain).

If I sell it now, then reinvest at 10% only to sell again in 10 years one gets the following after tax value:
(((($1000 * .85) * 1.1^10) - 850) * .85) + 850 = $2001.48

Now lets let it ride and just sell it after 10 years:
$1000 * 1.1^10 * .85 = $2204.68

As one has to expect there really is an advantage to delaying taxes all else being equal.

- Al
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Post by Michael Weiss »

I know that most Bogleheads have good intentions and are usually eager to help, but I am surprised to see people providing advice without knowing the names of the funds. Not all actively managed funds are bad and not all index funds are good. The mutual fund world isn't so black and white. Providing advice without knowing the names of the funds is like taking an exam without studying. In both situations, decisions would be made on limited knowledge and/or information.

Michael
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Post by gassert »

Al

i guess you're right, but not sure "why"
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Ted Valentine
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Post by Ted Valentine »

gassert wrote:Al

i guess you're right, but not sure "why"
Because I forgot to pay taxes again in example 1.

After I said you have $2301
I should have added if you sell it (again) you have $2083

D'oh!
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WHY INDEX FUNDS FOR US?

Post by Vig Oren »

IN MY CASE IT WOULD BE MADNESS
TO SWITCH TO INDEX FUNDS

I don’t see any advantage in performance for
my wife and I switching to index funds. We are
both retired and have been investing in active funds
for more than 30 years (which caused the cost
basis to be low, i.e. hi capital gains).
So it would be madness to exchange.

Comparing past performance of our portfolio to
portfolios of index funds:

.................................Annual average returns.%.......................
.....................all are 50% to 60% allocated to equities..........

Portfolio.....................YTD..................5 yrs..............10 yrs

Ours (all active)..........12......................17................12

Coffeehouse................7.4....................13.................7

Rick Ferri (book)..........8.5...................15.................7.4

Larry Swedroe (book)..10.....................15.................8.7

David Swensen (book)..11.....................16................8

So what is all the hoopla about index funds? :roll:
Last edited by Vig Oren on Thu Nov 01, 2007 9:23 pm, edited 2 times in total.
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Post by woof755 »

Michael Weiss wrote:I know that most Bogleheads have good intentions and are usually eager to help, but I am surprised to see people providing advice without knowing the names of the funds. Not all actively managed funds are bad and not all index funds are good. The mutual fund world isn't so black and white. Providing advice without knowing the names of the funds is like taking an exam without studying. In both situations, decisions would be made on limited knowledge and/or information.

Michael
I never meant to say that my actively managed fund was "bad." Quite the contrary, it has performed wonderfully. And waaaaayyyyyy more importantly, it got me into the stock market when I was 18 and didn't know what a mutual fund was.

The fund is American Funds Fundamental Investor, ticker ANCFX.
It holds about 73% domestic stock, large cap blend (recent migration to growth by M* classification) and 27% international equity, all developed markets.

The problems with it are:

1. Expense ratio of 0.58. Not too bad, really.
2. 5.75% load, but what the heck that's a sunk cost from 15 yrs ago.
3. 5% load on dividends.
4. The aforementioned tax inefficiency. After tax return is only 83% of pretax returns over the past 3 yrs.

My problem is, I just don't know how to put to use the M* tax cost ratio.

So, I have 8,000 in as an initial investment, and all the rest (20,000) is from dividends (sure, at a higher basis, which makes the math mind-boggling) and returns.

I would make the switch from ANCFX to VTSMX.

I assume that I have somewhere in the neighborhood of 18000 in cost basis in the fund (now that I'm reminded of dividends reinvested as an addition to my original basis).

So $10,000 in long-term capital gains at 15% is a $1,500 tax hit upon selling. Plus all the returns that that $1,500 would get me over the next 25 years.

So, the 24,500 (or so) would be reinvested in VTSMX for the next 30 years, at 0.4% lower expense ratio and in a much more tax-efficient manner.

Here is where I don't know how to calculate exactly how much money I'd save using VTSMX over ANCFX over the next 25 years.

Or, how long will it take me to make up the $1,500 (and its returns assuming it was still invested by me and not Uncle Sam) by virtue of a reduced ER and less yearly capital gains taxes?

Whew.
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woof755
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Post by woof755 »

For simplicity (I know, too late!), let's assume when estimating future returns that my entire portfolio will be rebalanced so that the money that used to be 75/25 domestic foreign is still that same ratio--I'll just move $$$ around in taxable accounts to keep my set asset allocation.
"By singing in harmony from the same page of the same investing hymnal, the Diehards drown out market noise." | | --Jason Zweig, quoted in The Bogleheads' Guide to Investing
Michael Weiss
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Post by Michael Weiss »

woof755 wrote: The problems with it are:

3. 5% load on dividends.

ANCFX has no load on dividends, so the argument for selling is reduced substantially. An expense ratio of 0.58 is very good. I am no fan of load funds. Most load fund families are not very good. The American funds are an exception.
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woof755
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Post by woof755 »

Well, here's what my most recent dividend reinvestment transaction says:


BOUGHT QUANTITY PRICE PRINCIPAL

FUNDAMENTAL INVS INC 6.31700 48.41000 305.80
CLASS A
SYMBOL ANCFX

TRADE INFORMATION: INITIAL SALES CHARGE 5.00%.
YOU MAY BE ELIGIBLE FOR BREAKPOINT DISCOUNTS BASED ON THE SIZE OF
YOUR PURCHASE, CURRENT HOLDINGS OR FUTURE PURCHASES. THE SALES CHARGE YOU PAID MAY DIFFER SLIGHTLY FROM THE
PROSPECTUS DISCLOSED RATE DUE TO ROUNDING CALCULATIONS. PLEASE REFER TO THE PROSPECTUS, STATEMENT OF
ADDITIONAL INFORMATION OR CONTACT YOUR FINANCIAL ADVISOR FOR FURTHER INFORMATION.
"By singing in harmony from the same page of the same investing hymnal, the Diehards drown out market noise." | | --Jason Zweig, quoted in The Bogleheads' Guide to Investing
Michael Weiss
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Post by Michael Weiss »

woof755 wrote:Well, here's what my most recent dividend reinvestment transaction says:


BOUGHT QUANTITY PRICE PRINCIPAL

FUNDAMENTAL INVS INC 6.31700 48.41000 305.80
CLASS A
SYMBOL ANCFX

TRADE INFORMATION: INITIAL SALES CHARGE 5.00%.
YOU MAY BE ELIGIBLE FOR BREAKPOINT DISCOUNTS BASED ON THE SIZE OF
YOUR PURCHASE, CURRENT HOLDINGS OR FUTURE PURCHASES. THE SALES CHARGE YOU PAID MAY DIFFER SLIGHTLY FROM THE
PROSPECTUS DISCLOSED RATE DUE TO ROUNDING CALCULATIONS. PLEASE REFER TO THE PROSPECTUS, STATEMENT OF
ADDITIONAL INFORMATION OR CONTACT YOUR FINANCIAL ADVISOR FOR FURTHER INFORMATION.
The prospectus for Fundamental Investors Class A says "None" for dividend reinvestment.
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Vig Oren
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Post by Vig Oren »

Aaron Woofter,

If you're with the American Funds and plan to amortize the commission over long time time then you can't beat them. But do minimum rebalancing in taxable accounts please. Once every presidential election is fine.

Last time that I rebalanced was in the beginning of 2003. I don't mind letting equity climb to 70% of portfolio and then reallocate to fixed income during good time.

p.s. please make notes to discuss at the RTP meeting :lol:
Last edited by Vig Oren on Thu Nov 01, 2007 9:39 pm, edited 2 times in total.
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grabiner
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Post by grabiner »

woof755 wrote:So $10,000 in long-term capital gains at 15% is a $1,500 tax hit upon selling. Plus all the returns that that $1,500 would get me over the next 25 years.

So, the 24,500 (or so) would be reinvested in VTSMX for the next 30 years, at 0.4% lower expense ratio and in a much more tax-efficient manner.

Here is where I don't know how to calculate exactly how much money I'd save using VTSMX over ANCFX over the next 25 years.
It's probably better to think of it as a percentage. If you pay the tax now, you will have $24,500 invested rather than $26,000, a 6% loss. Therefore, your VTSMX has to outperform ANCFX by 0.24% a year over those 25 years to break even (including the $10,000 lower capital gain when you sell).

I don't know how the two funds will do over the next 25 years, but one thing I do know which should be a reliable indication of the performance is that ANCFX costs about 1% more in taxes and higher expenses, and .10% in the load you are paying on the reinvested dividends.
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woof755
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Post by woof755 »

Vig Oren wrote:Aaron Woofter,

But do minimum rebalancing in taxable accounts please.


I am sensitive to this sentiment. It's why I'm struggling with the decision in the first place. I think given the taxes I'm paying on this thing every year, making the move to TSM would be worth it. As long as I really do leave everything in TSM for the long-haul and don't get tempted to mess around.

I don't think it's a terrible idea to leave it where it is...what I'm wondering is if I'm messing up the math and if it really is a terrible financial decision to leave it there and keep paying taxes.

The way I calculate it:

If both funds will earn 10% per year on average over the next 10 years, and on average, ANCFX owes 1.3% to taxes and 0.6% in ER, that's 8.1% to VTSMX's 9.5% (ER of 0.2% and 0.3% per year to taxes).

28,500 in ANCFX at 8.1% per year over 10 years equals $62,100.

After paying $1500 in cap gains, the remaining $27000 in VTSMX at 9.8% per year over 10 years equals 66,900.

Does this put me ahead $4800 after 10 yrs, or am I making a mistake?
"By singing in harmony from the same page of the same investing hymnal, the Diehards drown out market noise." | | --Jason Zweig, quoted in The Bogleheads' Guide to Investing
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Mel Lindauer
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Post by Mel Lindauer »

I don't think it's a terrible idea to leave it where it is...what I'm wondering is if I'm messing up the math and if it really is a terrible financial decision to leave it there and keep paying taxes.

The way I calculate it:

If both funds will earn 10% per year on average over the next 10 years, and on average, ANCFX owes 1.3% to taxes and 0.6% in ER, that's 8.1% to VTSMX's 9.5% (ER of 0.2% and 0.3% per year to taxes).

28,500 in ANCFX at 8.1% per year over 10 years equals $62,100.

After paying $1500 in cap gains, the remaining $27000 in VTSMX at 9.8% per year over 10 years equals 66,900.

Does this put me ahead $4800 after 10 yrs, or am I making a mistake?
Hi Aaron:

From what I've gathered from your posts, you're about ready to start making some serious big-time money now. Remember, not all distributions from funds (especially actively-managed funds) are long-term. Those short-term gains you might receive from an actively-managed funds will be subject to your (probably) very high tax bracket and not the 15% LTCG tax rates.

Something to think about.

Regards,

Mel
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Vig Oren
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Post by Vig Oren »

Aaron, I never referred to ER for calculating taxes. If anything I should refer to M* Tax Cost Ratio to find out if a fund is tax efficient. But I don't do it either. I pay attention to the Sharpe Ratio ( SR) under M* Risk Measure, and go by it, and sit on the fund for more than one year. The higher the SR is the better. Take for example the Dodge & Cox Stocks fund DODGX and the American Funds CAIBX. Why pay attention to their tax efficiency if they beat most funds, active and index, even after considering paying the higher tax on the distributions? And they do it by a LOT! Both in sheltered and taxable accounts.
Last edited by Vig Oren on Thu Nov 01, 2007 9:26 pm, edited 2 times in total.
InvestingMom
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Post by InvestingMom »

Ted Valentine wrote:
gassert wrote:Al

i guess you're right, but not sure "why"
Because I forgot to pay taxes again in example 1.

After I said you have $2301
I should have added if you sell it (again) you have $2083

D'oh!
To look at it another way, you are gaining the benefit of earning income on your deferred taxes. This is why a 401(K) is such a great vehicle (inaddition to being able to make pretax contributions) as well as why a Roth is such a great vehicle (even if you don't get pretax contributions.)

So if you are in a taxable account, IMHO, the best thing one can do is invest in an index fund and hold it until you need to rebalance or take a distribution, or even better yet hand it over to your heirs tax free! So not only can you create a similar tax environment as a roth, but you probably beat most actively managed funds (over the long haul.)

To answer the original poster's question, IMHO, you should bite the bullet.
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Speedy
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Post by Speedy »

Aaron:

A couple of comments on your calculations:

1. You did not adjust for the increased cost basis if you sell the existing fund and buy VTSMX. Existing fund has a cost basis of $18k. If you sell and buy VTSMX, it would have a cost basis of $27k. If you plan to spend the money in the future, you need to address the higher tax load at the time of sale. Of course, if you plan to bequeath or donate, it doesn;t matter.

2. I get different numbers on the FV calc. The proper equation is:

FV = PV * (1+r) ^ n where r = rate of return and n = number of years.

3. You prabably realize it, but something you mentioned earlier suggests maybe not: The published returns for mutual funds is net of operating expenses, but not loads

Other comments:

1. Active funds can generate unexpectedly high taxes should they have high turnover due to repositioning at some future point. This could happen in response to a changing market environment Much less likely in index funds.

2. Your fund, according to M* is 63% US stock, 27% Int'l, and 10% cash and bonds. This would be comparable to a 70/30 mix of VTSMX and VTISX.

3. Many people, including myself, believe there will probably be higher capital gains rates in the foreseeable future. Selling while gains rates are at historic lows could wind up being a very smart strategy for long term investors that intend to spend their money some day.

Regards,

Bill
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alvinsch
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Post by alvinsch »

woof755 wrote:
Vig Oren wrote:Aaron Woofter,

But do minimum rebalancing in taxable accounts please.


I am sensitive to this sentiment. It's why I'm struggling with the decision in the first place. I think given the taxes I'm paying on this thing every year, making the move to TSM would be worth it. As long as I really do leave everything in TSM for the long-haul and don't get tempted to mess around.

I don't think it's a terrible idea to leave it where it is...what I'm wondering is if I'm messing up the math and if it really is a terrible financial decision to leave it there and keep paying taxes.

The way I calculate it:

If both funds will earn 10% per year on average over the next 10 years, and on average, ANCFX owes 1.3% to taxes and 0.6% in ER, that's 8.1% to VTSMX's 9.5% (ER of 0.2% and 0.3% per year to taxes).

28,500 in ANCFX at 8.1% per year over 10 years equals $62,100.

After paying $1500 in cap gains, the remaining $27000 in VTSMX at 9.8% per year over 10 years equals 66,900.

Does this put me ahead $4800 after 10 yrs, or am I making a mistake?

The equation for calculating the after tax value of an investment with reinvested taxable distributions, liquidated at the end of the period is given as follows:

Return = [ (r + y)^n - t * (r-1) * ((r+y)^n - 1) / ((r+y) - 1) ]
r = unrealized cap gain
y = after tax distribution return
t = tax rate on cap gains
n = number of years.

So first let's calculate TSM return assuming 10% return of which 2% is distributed QDI/CGs taxed at 15% (0.3% TCR).
r = 1.08 (10% - 2% distributions)
y = 0.017 (2% * .85)
t = 0.15 (CG tax rate)
n = 10
result=(1.097^10) - (.15 * .08 * (1.097^10 - 1) / .097) = 2.335
so your $27000 would have an after tax value of $63054.35 in 10 years

Now let's calculate your ANCFX return assuming it has an ER 0.4% higher than TSM (.6% vs .2%) resulting in a 9.6% total return. Now let's assume it distributes 4% each year taxable at 15% (0.60% TCR) and then reinvested but with a 5% reinvestment load.
r = 1.056 (10% - 0.4% - 4%)
y = 0.0323 (4% * .85 *.95 reinvestment load)
t = 0.15
n = 10
result=(1.0883^10) - (.15 * .056 * (1.0883^10 - 1) / .0883) = 2.204
so the $28500 grows to $28500 * 2.204 - $1500 = $61317 in 10 years
note: $1500 covers tax on original unrealized gain

So using these assumptions (assuming I did the math correctly), after 10 years swapping would have already resulted in a much better after tax result.

Hope that helps.
- Al
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Vig Oren
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Post by Vig Oren »

Active vs. Index, current thoughts

(source: the no-load fund investor)

1) Index funds are more tax-efficient than virtually all actively managed funds.

2) The higher the taxrate on capital gains, the more attractive index funds become relatively to actively managed funds.


3) The greater the previous losses within a fund that may be harvested to offset realized capital gains, the more attractive the actively managed fund.

4) Any investor, who bets completely against index funds, is likely to lose out over time.


5) There are opportunities for active managers to provide strong risk-adjusted returns relative to indexes in various market conditions.

6) As part of broader portfolios, active funds can add to returns without some of the sector risk that an index- only approach can court.


7) After years of sub-par performance among large growth stocks, there are pockets of undervaluation in the area that a superior active manager should be able to exploit.

8] If you expect a significant bear market, switch some of the exposure in index funds toward more conservative actively managed counterparts.


9) The current 15% taxrate on long term capital gains is low, which favors actively managed funds. Many actively managed funds (especially growth-stocks) that suffered through the recent bear market continue to work-off their tax losses, thus decreasing their current capital-gains distributions. Once these losses are worked off, and if the taxrate increases on capital-gains distributions, then favor index funds more.

10) The merit of mixing index funds within a portfolio of active funds (and vice versa) is based on: current economic and investing environment, the sector diversification of the indexes, the availability of superior actively managed funds, and taxes.

Any comments?
Last edited by Vig Oren on Fri Nov 02, 2007 2:32 pm, edited 2 times in total.
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Tramper Al
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My simple calculations

Post by Tramper Al »

Hi,

I have a pretty simple "after tax" spreadsheet that I put together for exactly this sort of decision.

The basic input are the two ERs for the active and index funds, the two expected returns (which I generally set equal), the cap gains tax rate, the % unrealized gain in the initial position, and the dollar value of that position.

Then there is a row for today and each year into the future, with columns for "switch" account balance and after-tax value, and "stay" account balance and after-tax value.

For the "switch to index" columns, the account balance amount initially drops according to old basis and the cap gain rate. It then carries the new basis forward, to determine its "after tax" value in each subsequent year.

For the "stay with active" columns, there is the old account balance growing and then the year by year after-tax value.

You see, I consider the only relevant comparison to be after tax. Generally, even a modest ER advantage for the index fund will take an unexpected short few years to overcome the loss of continued deferral of the initial unrealized gain. After that, the index fund simply widens the gap further year after year.

Note too that my assumptions are very generous to the active fund, because I do not penalize it for its relative tax inefficiency.

For almost all of my decisions like this, it was clear that the break-even point would come very quickly, so I made the switch and paid the tax. Obviously, this is a time of relatively favorable cap gains tax treatments. In only one case have I run these calculations and decided to hold onto the active fun. It took its huge unrealized gain (>300%) and an ER just slightly above the index alternative for it to look wise to continue holding the active fund for now.

I hope this helps . . .
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