Wiki question - Paying a tax cost to switch funds

[Gennaro Dillinger]

Hi,

I wanted to use the template and plug in everything I'm left with after I finish taking losses and off-setting gains.

I now want to consider those items I might sell also but I am struggling a bit with the "Paying a tax cost to switch funds" wiki. I've downloaded the xlsx and have been playing with it but the rationale for some of the calculations still eludes me.

If I want to do this for some of my positions, how is the Total Return arrived at for each fund - 10 year trailing?

I assume tax on distributions at .30% is a ballpark for Fed and State?

Why are the distributions going to Fund B? Is that a BH-like fund and we don't want to keep reinvesting in one we are debating getting out of?

I assume for some items if the actual long-term gain is positive but not alot that it might just be worth selling it?

I assume LTCG at 15% is because no one would pay 20%?

Thanks!

[LadyGeek]

This thread is now in the Investing - Theory, News & General forum (general discussion).

I also retitled the thread for clarity. Here's the wiki page: Paying a tax cost to switch funds

(This thread was earlier thought to be part of the OP's portfolio thread Asking Portfolio Questions [Portfolio help request]. That was incorrect and is now a stand-alone topic.)

[retiredjg]

Gennaro, if I'm understanding the Wiki entry correctly, David Grabiner (a true numbers guy) is the one who last updated that spreadsheet. Maybe he can help you with your questions.

His poster name is Grabiner.

[Gennaro Dillinger]

Thanks!

[grabiner]

I answered this by PM, but I am also answering it here for the benefit of other readers.

If I want to do this for some of my positions, how is the Total Return arrived at for each fund - 10 year trailing?

It is your own estimate of the total return. A natural assumption in a comparison like this one is that returns will differ by the expense ratio, so if you are considering switching to a fund with 0.50% lower expenses, the total returns of the funds might be 7.5% and 8%.

I assume tax on distributions at .30% is a ballpark for Fed and State?

This is the percentage of the fund value lost to tax on distributions. In the example, the funds have a 2% yield, all qualified dividends, so you lose 0.30% to taxes on the dividends.

Why are the distributions going to Fund B? Is that a BH-like fund and we don't want to keep reinvesting in one we are debating getting out of?

The spreadsheet assumes that you are considering selling Fund A to buy Fund B despite the capital-gains tax. Given that, you would want to invest new money, such as the distributions from Fund A, into Fund B. The benefit from switching does not include the additional cost of reinvesting distributions into Fund A, since you can avoid that cost at no loss.

I assume for some items if the actual long-term gain is positive but not alot that it might just be worth selling it?

This is almost always the case. The purpose of the spreadsheet is to answer the same question when the gain on Fund A is fairly large; it may still be worth switching.

I assume LTCG at 15% is because no one would pay 20%?

The numbers in the spreadsheet are examples; you would fill in your own tax rate. For example, you might pay 21% tax on long-term gains because you pay 6% state tax. (You would also need to adjust the tax on distributions in this situation, as the tax cost of a 2% dividend would be 0.42%.)


Thanks!
[/quote]

[Gennaro Dillinger]

Many thanks

[mkc]

I answered this by PM, but I am also answering it here for the benefit of other readers.

I assume tax on distributions at .30% is a ballpark for Fed and State?

This is the percentage of the fund value lost to tax on distributions. In the example, the funds have a 2% yield, all qualified dividends, so you lose 0.30% to taxes on the dividends.

Might one use something like Schwab's "Tax Cost Ratio" on their mutual fund research for this? e.g. here's Fidelity Select Medical (FSMEX) https://www.schwab.com/research/mutual- ... risk/fsmex showing a 1.25 to 2.05% tax drag.

Or would you need to dig into prior years' distribution % and types?

[grabiner]

I answered this by PM, but I am also answering it here for the benefit of other readers.

I assume tax on distributions at .30% is a ballpark for Fed and State?

This is the percentage of the fund value lost to tax on distributions. In the example, the funds have a 2% yield, all qualified dividends, so you lose 0.30% to taxes on the dividends.

Might one use something like Schwab's "Tax Cost Ratio" on their mutual fund research for this? e.g. here's Fidelity Select Medical (FSMEX) https://www.schwab.com/research/mutual- ... risk/fsmex showing a 1.25 to 2.05% tax drag.

Or would you need to dig into prior years' distribution % and types?

Published tax cost ratios assume the highest federal tax rate and no state tax, so they may not correspond to your own tax cost; you may need to make an estimate based on your own tax situation. In addition, the main source is Morningstar, which doesn't always know about qualified dividends; you will sometimes see different tax cost ratios for Admiral and ETF share of the same Vanguard fund. (You can get a better tax number from the fund provider, which will know whether dividends are qualified.)

You may also need to understand the reason for past distributions, as future distributions may change. For example, most bond funds will have a higher tax cost going forward than they did over the last five years, since bond yields now are higher. And Vanguard Target Retirement funds are not likely to repeat the huge capital gain distributions they had in 2021, which were caused by 401(k) plans switching share classes.

[Gennaro Dillinger]

OK, can I ask for a sanity check? I am not sure I am using this .xlsx properly. I'd greatly appreciate if someone can tell me if I'm not properly analyzing this. Using the spreadsheet in the wiki I am evaluating: BGRIX

Cost: $41,367
Value: $58,863
Expense ratio: 1.03%
Yield & Div: 0.04%
TTR 10yr: 13.41%

VTI
ER: 0.03%
Yield: 1.48%
TTR 10 yr: 12.52%

When I run this it shows that it is never worth paying the tax - the after tax value of Fund A (BGRIX) is always ahead of Fund B (VTI).

I did not change 'tax on distributions' from 0.30%.

[grabiner]

OK, can I ask for a sanity check? I am not sure I am using this .xlsx properly. I'd greatly appreciate if someone can tell me if I'm not properly analyzing this. Using the spreadsheet in the wiki I am evaluating: BGRIX

Cost: $41,367
Value: $58,863
Expense ratio: 1.03%
Yield & Div: 0.04%
TTR 10yr: 13.41%

VTI
ER: 0.03%
Yield: 1.48%
TTR 10 yr: 12.52%

When I run this it shows that it is never worth paying the tax - the after tax value of Fund A (BGRIX) is always ahead of Fund B (VTI).

I did not change 'tax on distributions' from 0.30%.

This is because you are assuming that BGRIX (Baron Growth) will outperform VTI by the same amount that it did over the last ten years. If it actually does that, you will be better off not switching.

However, past performance is not an indication of future results. The break-even calculation requires that you make an assumption of future returns, and a natural assumption is that funds will match the market return minus the expense ratio. Try the calculation again assuming a 1% return difference in favor of VTI. (Baron Growth is likely to perform differently from the market, whether better or worse, because it is a mid-cap growth fund; it will outperform if small-cap and growth outperform large-cap and value, but could just as well do the opposite.) When I use the tool, I normally assume 8% for a stock market return, so the numbers would be 7% and 8%.

Also, the "tax on distributions" is an important consideration. Baron Growth has distributed very little in dividends, but about 5% per year in long-term capital gains, which would be a tax cost of 0.75%.

[Gennaro Dillinger]

OK, can I ask for a sanity check? I am not sure I am using this .xlsx properly. I'd greatly appreciate if someone can tell me if I'm not properly analyzing this. Using the spreadsheet in the wiki I am evaluating: BGRIX

Cost: $41,367
Value: $58,863
Expense ratio: 1.03%
Yield & Div: 0.04%
TTR 10yr: 13.41%

VTI
ER: 0.03%
Yield: 1.48%
TTR 10 yr: 12.52%

When I run this it shows that it is never worth paying the tax - the after tax value of Fund A (BGRIX) is always ahead of Fund B (VTI).

I did not change 'tax on distributions' from 0.30%.

This is because you are assuming that BGRIX (Baron Growth) will outperform VTI by the same amount that it did over the last ten years. If it actually does that, you will be better off not switching.

However, past performance is not an indication of future results. The break-even calculation requires that you make an assumption of future returns, and a natural assumption is that funds will match the market return minus the expense ratio. Try the calculation again assuming a 1% return difference in favor of VTI. (Baron Growth is likely to perform differently from the market, whether better or worse, because it is a mid-cap growth fund; it will outperform if small-cap and growth outperform large-cap and value, but could just as well do the opposite.) When I use the tool, I normally assume 8% for a stock market return, so the numbers would be 7% and 8%.

Also, the "tax on distributions" is an important consideration. Baron Growth has distributed very little in dividends, but about 5% per year in long-term capital gains, which would be a tax cost of 0.75%.

Thanks very much - much clearer now, too.

I used Fund A at 4.97% total return and Fund B VTI at 6% as ER was 1.03% for BGRIX. The breakeven now is about 3.5 years. BUT...

When I change the tax on distributions for fund A to 0.75% and leave it at 0.30 for VTI the breakeven is about 1 year.

Is the tax cost of 0.75% because 5% of 15% is 0.75%? So that's the factor to use for the whole fund?

Best regards

[grabiner]

Also, the "tax on distributions" is an important consideration. Baron Growth has distributed very little in dividends, but about 5% per year in long-term capital gains, which would be a tax cost of 0.75%.

Thanks very much - much clearer now, too.

I used Fund A at 4.97% total return and Fund B VTI at 6% as ER was 1.03% for BGRIX. The breakeven now is about 3.5 years. BUT...

When I change the tax on distributions for fund A to 0.75% and leave it at 0.30 for VTI the breakeven is about 1 year.

Is the tax cost of 0.75% because 5% of 15% is 0.75%? So that's the factor to use for the whole fund?

Yes, this is correct. If a fund distributes 5% of its value every year, and that 5% is all long-term capital gains, you will lose 0.75% to tax (assuming the usual 15% tax rate).

[Gennaro Dillinger]

Also, the "tax on distributions" is an important consideration. Baron Growth has distributed very little in dividends, but about 5% per year in long-term capital gains, which would be a tax cost of 0.75%.

Thanks very much - much clearer now, too.

I used Fund A at 4.97% total return and Fund B VTI at 6% as ER was 1.03% for BGRIX. The breakeven now is about 3.5 years. BUT...

When I change the tax on distributions for fund A to 0.75% and leave it at 0.30 for VTI the breakeven is about 1 year.

Is the tax cost of 0.75% because 5% of 15% is 0.75%? So that's the factor to use for the whole fund?

Yes, this is correct. If a fund distributes 5% of its value every year, and that 5% is all long-term capital gains, you will lose 0.75% to tax (assuming the usual 15% tax rate).

Hi Grabiner,

I know this is fundamental but I cannot locate where it shows BGRIX is distributing 5%/year. Searching on line, prospectus, TDA website...no luck. Can you point me? Thanks

[grabiner]

I know this is fundamental but I cannot locate where it shows BGRIX is distributing 5%/year. Searching on line, prospectus, TDA website...no luck. Can you point me? Thanks

I went to morningstar.com, clicked on "Performance", and then on "Distributions". This shows the last ten distributions from the fund, and in a fund like this which pays almost no dividends, that included ten years of capital gains.

[Gennaro Dillinger]

First, thanks, Grabiner! I finally got the tool straight in my head with your direction. Many thanks.

OK. I have six funds left in my taxable account that I am calculating if it is worth paying tax and be done with them. I find the results interesting. Any thoughts greatly appreciated.

Fund Breakeven
BGRIX Year 1
BPTIX Year 1
SWHFX Year 1
VMIAX VERY close in the initial years but ultimately Fund A (VMIAX) is $17K greater after 30 years
VMVAX VERY close in the initial years but ultimately Fund A (VMVAX) is $17K greater after 30 years
VSMAX Fund B (VTI) breakeven year 1 and slowly pulls ahead over 30 years. In ten years it is $9k ahead.

• I bumped LTCG to 18.07% as I am in PA and the state LTCG tax is 3.07%.

• I set total return for VTI at 6% and then set Fund A total return at 6%-Fund A ER.

• Where I didn’t have enough data on distributions, I used what I could get. E.g., I had 2.5 years data for VMVAX, 4/year and 2 for 2022 so ten total. I divided the total income by 2.5 to annualize it.

• All of them had two-digit gain, between 25-78% except for BPTIX. BPTIX was 363% with a cost of $41,896 and Mkt value of $193,987. I assume it is the high distributions which I calculated at 8.63% for the last 2.5 years using Morningstar data that pushed it to a ‘yes’ for selling and paying the tax.

[grabiner]

First, thanks, Grabiner! I finally got the tool straight in my head with your direction. Many thanks.

OK. I have six funds left in my taxable account that I am calculating if it is worth paying tax and be done with them. I find the results interesting. Any thoughts greatly appreciated.

Fund Breakeven
VMIAX VERY close in the initial years but ultimately Fund A (VMIAX) is $17K greater after 30 years
VMVAX VERY close in the initial years but ultimately Fund A (VMVAX) is $17K greater after 30 years
VSMAX Fund B (VTI) breakeven year 1 and slowly pulls ahead over 30 years. In ten years it is $9k ahead.

(These three funds are Vanguard Mid-Cap Index, Mid-Cap Value Index, and Small-Cap Index.)

For these three, the decision to sell is a different issue. All three of these funds are fine in a taxable account, as they are low cost index funds with an ETF class and are unlikely to distribute capital gains. So, do you want to overweight mid-caps, small-caps, and value? If so, you should keep them. If not, you could sell them to simplify your portfolio, or hold them and plan to use them eventually for charitable contributions.

[Gennaro Dillinger]

First, thanks, Grabiner! I finally got the tool straight in my head with your direction. Many thanks.

OK. I have six funds left in my taxable account that I am calculating if it is worth paying tax and be done with them. I find the results interesting. Any thoughts greatly appreciated.

Fund Breakeven
VMIAX VERY close in the initial years but ultimately Fund A (VMIAX) is $17K greater after 30 years
VMVAX VERY close in the initial years but ultimately Fund A (VMVAX) is $17K greater after 30 years
VSMAX Fund B (VTI) breakeven year 1 and slowly pulls ahead over 30 years. In ten years it is $9k ahead.

(These three funds are Vanguard Mid-Cap Index, Mid-Cap Value Index, and Small-Cap Index.)

For these three, the decision to sell is a different issue. All three of these funds are fine in a taxable account, as they are low cost index funds with an ETF class and are unlikely to distribute capital gains. So, do you want to overweight mid-caps, small-caps, and value? If so, you should keep them. If not, you could sell them to simplify your portfolio, or hold them and plan to use them eventually for charitable contributions.

I am thinking it may just be simpler to keep them. They are certainly not a pressing issue in any respect. Thanks, again.