Paying a tax cost to switch funds

The situation
Suppose that you have a fund in a taxable account, and you have an alternative fund with lower costs or lower taxes. You would like to switch, but you have capital gains in the old fund, and would need to pay taxes if you switch. Usually, the long-term advantage of the lower-cost fund will outweigh the short-term cost of switching. There is a link below to a spreadsheet which you can use to estimate the comparison.

If you decide not to switch, or will take some time deciding, do not reinvest any dividends or capital gains in the old fund; you do not want to buy more shares of a fund which is costing you in taxes.

Rules of thumb
If the annual difference in taxes and costs is more than 10% of the tax you would pay, you should almost always switch. If the difference is less but it is mostly an expense difference, multiply the amount saved per year by the number of years you expect to hold the fund, and if that is equal to, or even close to, the tax cost, then you should come out ahead by switching. If the difference is less but it is mostly caused by the higher-expense fund having more long-term gains, you'll have to work out the difference more carefully.

The potential gains from switching
While the cost of switching is easy to measure, the potential gains include an indirect gain from a higher tax basis as well as the direct gain from lower costs. If you keep the old fund, you will still sell it eventually and pay taxes on your capital gains, and thus keeping the fund does not save you the full value of the taxes, as it only delays the payment. For example, if you sell $20,000 of the old fund with a $10,000 basis and pay $1,500 in tax, you will have a new fund with $18,500 invested and an $18,500 basis. Thus you will avoid re-paying tax on $8,500 of gains when you sell the new fund.

This explains the 10% rule of thumb. In the example above, suppose that you hold the new fund for one year and one day (so that the gains are taxed at the long-term rate), the new fund gains 10% after tax, and the old fund gains 9.25% after tax, a difference of 10% of the capital-gains tax cost. The new fund will be worth $20,350, and if you sell it then, you will pay $278 tax on the $1,850 gain, so your after-tax value is $20,072. The old fund would be worth $21,850, and if you sold it then, you would pay $1,778 tax on the $11,850 gain, also ending with $20,072. If the market returns are less than 10%, the new fund is better even after one year.

The higher tax basis is also the reason for the "close" in the second rule of thumb; if the new fund grows to be worth almost as much as the old fund would have been worth, then the tax savings will cause it to come out ahead after you sell.

Examples
Here are some examples worked out with the spreadsheet in the Links section.

In all of these examples, Fund B returns 8% annually, with 2% in qualified dividends giving it a 7.7% after-tax return, and your basis in Fund A is half the current value (7.5% tax if you sell). It is also assumed that the current (2008) tax rates will not change, with long-term gains and qualified dividends taxed at 15%.

If Fund A costs an extra 0.50% over Fund B with the same distributions, for a 7.2% after-tax return, then it takes eight years to break even if you switch, assuming you reinvest all dividends in Fund B if you keep Fund A.

If Fund A costs an extra 0.50% over Fund B and the extra cost comes out of the qualified dividend yield (giving Fund A a 7.27% after-tax return), then it takes nine years to break even.

If Fund A and Fund B have the same costs but Fund B has 2% distributions with 0.30% in tax (all qualified dividends) while Fund A has 4% distributions with 0.80% in tax (a mixture of short-term and long-term gains in addition to the dividends), then it takes 27 years to break even. Thus the effective cost is just 0.28%; 0.20% is completely lost because it is the tax difference between short-term and long-term gains, while the other 0.30% of taxes on gains has an effective cost of only 0.08% because the lower turnover of Fund B allows your gains to grow longer before being taxed but does not avoid the tax.

Clear indications for switching
This discussion assumes that the only reason you want to switch funds is the cost savings. If you hold a fund which is no longer appropriate for you (for example, you hold too much stock for your current asset allocation), you should pay the tax cost even if it might represent a net dollar loss.

If the cost for switching is a deferred load (shares in such funds are often called B shares), you should ignore the deferred load when selling, and sell now if that is the only cost. The reason is that you will have to pay the deferred load whether you sell or not, so you should treat it as money which you have already lost but which has not been deducted on your statement. For example, a typical B share fund might charge a 5% load which goes away gradually if you hold the fund for six years, but charge a 1% annual 12b(1) fee which, like a load, goes to compensate the broker. Thus, if you have held the fund for less than one year and sell, you will lose 5% of your investment to the sale; if you hold it until the load goes away, you will lose 5% in the 12b(1) fee by holding the fund five years. (Vanguard funds do not have such deferred loads; if you are considering switching out of a Vanguard fund which has a redemption fee, add the redemption fee to any tax cost in your decision whether to switch.)

Another way to get rid of the fund
If you have long-term gains in a fund you do not want to keep, you can avoid paying the capital-gains tax entirely by donating it to charity. The charity won't owe any tax on the gains, and you can usually get a tax deduction for the full value of the fund.

Links

 * Spreadsheet for comparing the costs of switching versus keeping the fund