Altering investments while in a high tax bracket

[jaysee]

Hey all,

I have a bit of an interesting problem to work through.

Over the years I built up my main nest-egg in Vanguard funds (about 70% of my net worth).

Now I've found what I consider to be slightly superior investments (actively managed multi-factor funds with lower rates than my Vanguard indexes and which I expect to generate a ~1% annual net return greater than the market).

The problem is, I'm in the highest tax bracket imaginable, as I currently work two full-time jobs which are both very well remunerated. Plus my Vanguard investments have done very well, as you can probably imagine from looking at market performance over the 2017-2021 period.

So I'm wondering how to go about selling the Vanguard and buying the multi-factor funds.

1. All in one go? Pros: I can begin to benefit from the expected 1% over-performance earlier. Cons: I'll get taxed at the highest marginal tax rate for the growth over the time I've held them, which will be substantial. (Though, fortunately, according to the Australian Taxation Office, the tax will be half the regular income tax, since I held them longer than 1 year; so that's about 15%.)

2. In smaller chunks? Pros: I can lessen the tax burden, as I'll be selling smaller chunks, therefore generating smaller capital gains, therefore paying less capital gains tax, therefore paying less tax overall in total. Cons: I'll miss out on the opportunity to capture the extra 1% performance of the multi-factor funds. Also there's a bit of complication involved in determining precisely how big the chunks should be.

3. Wait until I retire? Pros: I'll be living frugally, thus I'll be in the lowest tax band, thus, I can pay little or no CGT on selling, especially if I sell in chunks. Cons: That could be another few years, during which I'll miss out on the 1% out-performance of the multi-factor funds.

4. Don't alter the portfolio at all? Maybe, given the CGT tax I'd be paying if I altered the portfolio, the most efficient option is just to never alter it at all? Simply wait until FIRE date, then just live off selling small chunks of the funds, according to my original plan? (This will probably work out well in any case, so there's no major downside to this plan.)

In summary I'm trying to figure out whether the tax from altering my investments would override the potential gains from being invested in better performing funds.

I guess, thinking about it, this is all just fiddling around the edges. My basic plans are probably going to work out in any case, all else equal. I'm just chasing an extra 1% return, as I believe this could add up to be quite substantial over a long period of time I expect to remain invested (40+ years, and I want to pass it on to younger family members also).

Any thoughts from anyone in a similar situation would be much appreciated!

BTW - the funds I'm looking to get into are:

* Dimensional Core International Equity (DFAI)
* Dimensional Core US Equity (DFAU)
* Dimensional Core Emerging Equity (DFAE)

[electriceagle]

Nice problem to have.

Calculate the tax due if you sell now and the tax due if you sell over time after ceasing to work (assuming that the tax laws stay the same). Figure out how many years of the the 1% additional gain that you intend to accumulate the tax will eat up. That should make it pretty easy to decide.

[SeattleCPA]

I would surprised if the tax drag on rebalancing and then the incremental expenses didn't eat up any incremental return you hope to earn.

Note: I know nearly nothing about Australian tax rates...

My thinking is colored by an assumption that capital market returns over coming years lower than what we've all happily enjoyed:

https://evergreensmallbusiness.com/financial-game-plans-for-low-interest-rates/

P.S. For context, I use David Swensen's asset allocation formula... so 70% equities, 30% US treasuries.

[MustacheAndaHalf]

I enjoyed Larry Swedroe's books, but gave up on small/value years ago.  Swedroe often compared Dimensional funds to benchmarks like the S&P 500.

Since Dimensional ETFs are only a few months old, I needed to look at their prior incarnation as mutual funds.  It looks like Vanguard Total Stock Market beats DFA US Core Equity (DFEOX) over each time frame: 1, 3, 5, and 10 year performance.  You might both pay taxes, and then get worse performance:
https://www.morningstar.com/etfs/arcx/vti/performance
https://www.morningstar.com/funds/xnas/dfeox/performance

[marty998]

Yeah as Seattle CPA mentioned the dirty little secret of the funds management industry is that returns are generally always quoted gross of your tax position.

I had a sneak peak at that international fund... it has 5000 sticks in its portfolio, with those evil bastards Nestle at #1), so that adds up to a lot of buying and selling to rebalance.

The long term performance returns are also not 1% above benchmark... since inception it says 0.6% but you might pay that in entry spread fees every time you want to buy, in addition to additional tax on capital gain distribution components.

Did you actually make it back to Australia? I seem to recall you were working overseas.

[jaysee]

Since Dimensional ETFs are only a few months old, I needed to look at their prior incarnation as mutual funds.  It looks like Vanguard Total Stock Market beats DFA US Core Equity (DFEOX) over each time frame: 1, 3, 5, and 10 year performance.  You might both pay taxes, and then get worse performance:
https://www.morningstar.com/etfs/arcx/vti/performance
https://www.morningstar.com/funds/xnas/dfeox/performance

Interesting, thanks for bringing this up.

I wondered if it was an apples-applies comparison to compare Dimensional US with Vanguard Total Stock Market. Wouldn't it be better to compare DFEOX with, say, Vanguard Total US Shares?

But in the above comparison, it looks like what you say still holds - the Vanguard fund outperforms the Dimensional fund on average:

Year	DFA Return	VTA Return
2011	-0.64	1.08
2012	16.91	11.03
2013	36.6	57.75
2014	10.52	24.32
2015	-1.35	12.71
2016	14.8	13.1
2017	20.89	12.33
2018	-7.79	4.28
2019	30.18	31.85
2020	16.42	9.88
Average	13.654	17.833

I guess I was listening to too much DFA marketing and not checking the actual statistics (d'oh!)

[jaysee]

Yeah as Seattle CPA mentioned the dirty little secret of the funds management industry is that returns are generally always quoted gross of your tax position.

I had a sneak peak at that international fund... it has 5000 sticks in its portfolio, with those evil bastards Nestle at #1), so that adds up to a lot of buying and selling to rebalance.

The long term performance returns are also not 1% above benchmark... since inception it says 0.6% but you might pay that in entry spread fees every time you want to buy, in addition to additional tax on capital gain distribution components.

Yes it looks like they're just good at marketing their funds and appealing to the index fund crowd, while not offering significant better net returns.

And after paying all the taxes on selling down the Vanguard funds I'd almost definitely be in a worse position.

Did you actually make it back to Australia? I seem to recall you were working overseas.

Yes luckily I did make it back. Saw the signs of COVID disruption as early as March and booked a return flight right then & there.

I'm missing the UK a bit... I didn't realise how much I'd grown to like the work, pub and general living culture over there. On the other hand, I guess it was all going to be locked down anyway and there's plenty to do back in Australia, plus I'm not limited in who I work for by the work visa, as I was in the UK.

[jaysee]

My thinking is colored by an assumption that capital market returns over coming years lower than what we've all happily enjoyed:

Yep, same here. Rather than the usual 4% rule, I've adjusted my lifestyle according to an assumption of a 2% rule.

If the real return turns out to be less than 2%, it should be easy enough to make up the difference with some combination of working part-time or part-year and living more frugally.