Guidelines to help determine whether to stay put or sell.
Over the past two years, U.S. equities have delivered very strong returns. The one downside is that in both years, you received large capital gains distributions from your U.S. equity fund investment. If you had no personal loss carryforwards, you had to cut a check to Uncle Sam when you filed your 2013 tax returns and will have to do so again for your 2014 taxes. Another significant concern is that this fund has been underperforming a comparable index fund over the past three and five years, annualized. However, you have held this fund in a taxable account for a long time, and your cost basis is significantly lower than the current net asset value. In other words, selling this fund to move into an index fund or exchange-traded fund will result in a large capital gains tax liability. But if the index fund outperforms your current fund in the coming years, and if the index fund generally does not make capital gains distributions, then it may be worth it to sell the current fund, pay the capital gains tax, and move into a cheap index fund. So, how do you decide whether to stay in the old (underperforming/overpriced) fund or move to a new (cheap index) fund?
There is no straightforward answer, as there are many variables that can affect this decision. The goal is to determine under which assumptions you will break even in a time period that is acceptable to you. The first thing to do is identify the known variables, and for the unknown variables, run a few scenarios using a range of reasonable estimates. (I have created a simple Excel model to run these scenarios; email me for a copy.) Incidentally, my colleague Christine Benz wrote an article about what you need to consider before moving out of funds and into ETFs, and many of her points are relevant for this discussion.
What You Know Now
1) The Capital Gains Tax Liability if You Sell the Fund Today
If you move money from the old fund into an index fund, the money available for the new fund will be net of taxes on realized capital gains. That means the amount you pay in taxes, and any future potential compounding gains on that amount, will not be in your portfolio.
2) Current Capital Gains Tax Rates
If you expect capital gains tax rates to rise (which may be a reasonable assumption given the ever-rising U.S. debt levels), you might want to realize large capital gains sooner rather than later.
3) The Taxes on Long-Term Capital Gains
Taxes on long-term capital gains are 0% for those in the 10% and 15% ordinary income tax brackets. This is relevant for those (such as retirees or individuals who are self-employed or in between jobs) who can manage their income to remain within the 10% and 15% ordinary income tax brackets. This is also relevant for those who are near retirement and who also expect that they will fall in the 10% and 15% ordinary income tax brackets. If you are in the bottom two tax brackets, and if you don’t need the money, you can "harvest" tax-free capital gains and reinvest in an index fund at a higher cost basis.
What to watch for: Capital gains are included as income, so once you cross into the 25% ordinary income tax bracket, you will be liable for a 15% long-term capital gains tax on the amount that falls in the 25% ordinary income tax bracket. In addition, this harvesting capital gains strategy may also affect certain deductions, tax credits, and the taxation of Social Security.
4) How to Avoid Paying Capital Gains Taxes by Gifting Appreciated Securities
You can gift fund shares to individuals (children, retired parents) who fall in the 10% and 15% ordinary income tax bracket. Gifts are tax-free as long as your total annual gift is $14,000 or less, per recipient. You can also gift shares to charitable organizations, if they can accept mutual fund shares.
5) Many Cheap Alternatives
Vanguard index funds and ETFs, iShares Core ETFs, and Schwab Market-Cap Index ETFs offer very cheap exposure to popular asset classes across the Morningstar Style Box.
What You Need to Estimate
1) How Your Old Fund Will Perform Relative to the Index Fund
Forecast a range for what you think the old fund’s performance will be relative to a comparable index fund. You can use the old fund’s three- and five-year annualized performance relative to a comparable index fund or the fee differential between the old and new fund. A reasonable start would be to use negative 0.5%, negative 1.0%, and negative 1.5%.
What to watch for: While this is almost impossible to predict, should your old fund significantly outperform a comparable index fund in the next year or two, staying put may be the better decision.
2) Capital Gains Distributions
To keep things simple, assume that all capital gains are taxed at the same rate. For the old fund, forecast a range of capital gains as a percent of NAV, based on historical trends. To reflect the economic impact of these distributions, the taxes paid should be deducted from the value of the portfolio at year-end. However, it is also important to note that these capital gains reduce the fund’s accumulating unrealized capital gains. On the other hand, for the index fund, assume that it does not make a capital gains distribution, and that unrealized gains accumulate as the fund’s NAV rises. This tax deferment by index funds is generally beneficial for long-term investors. This is because instead of paying out distributions, these gains remain within the fund and continue to grow. In addition, investors who liquidate when they are in retirement may be able to manage their income so that they fall in lower ordinary income tax brackets.
What to watch for: Individuals in the 15% and 10% income tax brackets do not pay taxes on long-term capital gains, so they should look at preliquidation balances when trying to determine their break-even points.
Other Issues to Consider
1) A Strong Market Rally
If you don’t move your money now, and if markets rally in 2015, you will have an even larger unrealized capital gain in your old fund by year-end.
2) High Market Volatility in the Coming Years
In a volatile market environment, other areas of your portfolio might have unrealized losses, which you can use to offset the gains from the old fund, if you decide to keep the fund.
3) Harvesting Losses to Offset Gains
If this fund is a separately managed account, you can opportunistically harvest losses to offset gains. However, if you are selling only parts of the portfolio, you could see significant tracking error, if you pursue this strategy over a number of years.
1) You can recoup an upfront tax liability under fairly reasonable scenarios. If unrealized gains account for 25% of your portfolio, and if your old fund underperforms a comparable index fund by 20 basis points a year in 2015, 2016, and 2017, you will be ahead by the end of 2017. If unrealized gains account for 50% of your portfolio, and if your old fund underperforms by 40 basis points for four consecutive years, you will be ahead by 2018. If your old fund's underperformance is greater, you will break even sooner.
2) If you expect your old fund to perform in line or better than a comparable index fund, it is better to stay put. Remember that moving into an index fund requires paying taxes on realized gains, whereas if you stayed put, that tax liability stays in your portfolio and is able to grow.
3) Expenses matter. Lower costs generally lead to superior returns, and this applies to both actively managed and passively managed strategies. If your old fund’s expense ratio is above the median of its Morningstar Category (you can check this under the Expenses tab on Morningstar.com) and if it doesn’t carry a Morningstar Medalist rating, it may be a good idea to move.
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