Author Topic: Math Question Do I take a tax hit now in favor of a better expense ratio?  (Read 4658 times)

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
Ok all you math nuts Mustachians... We are still trying to decide what to do.

I ask this question in this thread last year, actual about a year ago...

http://forum.mrmoneymustache.com/investor-alley/unrealized-gains-in-unwanted-mutual-funds/msg127203/#msg127203

I thought I decided to sell the funds, but we in doing further analysis they really don't underperform. It is hard to justify the sale. Especially with the high tax bill. So I thought I would put it out there again this year for some fresh perspective and see if there was any new insight.

My wife has 3 mutual funds and I am not even sure if they were bought or gifts based on their age.

Anyway they are American Funds, all A shares so they were front loaded, that is a sunk cost can't cry over spilt milk it doesn't really matter any more any anyway.

In doing our analysis these particular funds have done fairly well in the past all things being equal. That being said we really would rather not own them, they don't fit into our current portfolio thinking and they have high expense ratios, I don't imagine they will outperform in the future, however they will most likely perform well enough.

The 3 funds are:

Fund #1 :ABALX with an expense ratio of .61 it is benchmarked against a combined 60/40 split of the S&P 500 and the Barclays total bond market, so if I were to compare them to the iShares ETF's (I trade at Fidelity, no charge for iShares), the combined expense ratio for a 60/40 split of IVV/AGG  is .074.

Fund #2: AGTHX with an expense ratio of .76 is benchmarked against the S&P 500, so we would use IVV expense ratio .07

Fund #3: ANWPX with an expense ratio of .85 is benchmarked against the MSCI Developed World Index including US, the iShares equivalent is URTH with an expense ratio of .24, not sure if this would trade free, might be a $7.95 commission.

These funds have been owned for a long time, in the 10 year time frame, they have a lot of built in gains, we live in NYS and our income puts us in the 15% federal capital gains bracket. So our total growth hurdle is going to be 21.85% to break even on the tax hit. I have no available losses to harvest, so I can't offset the gains at all.

So the question is do I hold onto the funds or sell them?

I will provide a table with the relevant data, there is no way to know if the mutual funds will under/over perform, in the past they did a fairly good job, however I am not sure what that means for the future. And the tax hit is pretty large but so are the expense ratio differences... So I am not sure where to go with this.


SymbolCurrent ValueGainTaxNet Gain Reinvestment AmountExpense Ration Diff
ABALX$21,048.95$6,088.77$1,330.40$4,758.37$19,718.550.536
AGTHX$42,660.43$24,739.10$5,405.49$19,333.61$37,254.940.69
ANWPX$8,473.35$3,313.69$724.04$2,589.65$7,749.310.61
Total$72,182.73$34,141.56$7,459.93$64,722.80

-Mister FancyPants

MDM

  • Walrus Stache
  • *******
  • Posts: 9711
Mr FP: 'fraid my crystal ball isn't any clearer.  I think the equations you want are the ones below.

B             Tax basis of current account
FV1          Amount in the account after n years if you withdraw now.  This is the amount heirs would receive if you do not withdraw in the future.
FV2          Amount in the account after n years if you hold now.  This is the amount heirs would receive if you do not withdraw in the future.
Net1        Amount available if you withdraw now and withdraw again after n years.
Net2        Amount available if you hold now and withdraw after n years.
NewB      New balance (and new tax basis) if funds are withdrawn now
CGrate1  Current capital gains tax rate (15% per OP)
CGrate2  Capital gains tax rate in effect after "n" years
CV           Current value of account
n             Number of years into the future
r1            Return expected from current account
r2            Return expected from Fidelity

NewB = CV - (CV - B) * CGrate1

FV1 = NewB * (1 + r1)^n

Net1 = FV1 - (FV1 - NewB) * CGrate2


FV2 = CV * (1 + r2)^n

Net2 = FV2 - (FV2 - CV) * CGrate2


I'm guessing that you could put these into a spreadsheet and play "what if?" to judge sensitivities. 
Do these look correct?
What answer(s) do you get for your situation?

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
Mr FP: 'fraid my crystal ball isn't any clearer.  I think the equations you want are the ones below.

B             Tax basis of current account
FV1          Amount in the account after n years if you withdraw now.  This is the amount heirs would receive if you do not withdraw in the future.
FV2          Amount in the account after n years if you hold now.  This is the amount heirs would receive if you do not withdraw in the future.
Net1        Amount available if you withdraw now and withdraw again after n years.
Net2        Amount available if you hold now and withdraw after n years.
NewB      New balance (and new tax basis) if funds are withdrawn now
CGrate1  Current capital gains tax rate (15% per OP)
CGrate2  Capital gains tax rate in effect after "n" years
CV           Current value of account
n             Number of years into the future
r1            Return expected from current account
r2            Return expected from Fidelity

NewB = CV - (CV - B) * CGrate1

FV1 = NewB * (1 + r1)^n

Net1 = FV1 - (FV1 - NewB) * CGrate2


FV2 = CV * (1 + r2)^n

Net2 = FV2 - (FV2 - CV) * CGrate2


I'm guessing that you could put these into a spreadsheet and play "what if?" to judge sensitivities. 
Do these look correct?
What answer(s) do you get for your situation?

MDM... I think I got a little lost at first with your variable names but in re-reading while I replied I see what you are doing.

What I plan on doing is probably going back the one year since my last thread and seeing what returns I would have gotten had I pulled the trigger.

Also going to just compare straight returns disregarding the tax side of to compare the funds.

If in the future Cap Gains tax drops to 0% holding out might make sense, or I have future losses to take the gains against. My problem is the returns are close enough even with the big expense ratio difference that the tax hurdle is hard to justify. I need stronger batteries in the crystal ball :)

Oh the only number you have wrong is my cap gains rate is 21.85% Fed + NYS.

beltim

  • Magnum Stache
  • ******
  • Posts: 2848
What do you anticipate your capital gains tax rate to be when you eventually want the money (e.g. in retirement)?  Assume capital gains tax rates are unchanged between now and when you want to take the money out.

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
What do you anticipate your capital gains tax rate to be when you eventually want the money (e.g. in retirement)?  Assume capital gains tax rates are unchanged between now and when you want to take the money out.

The question of the day... I can hope for 0% in which case it makes sense to hold out... but like MMM I will probably wind making money indefinitely even if I plan not to... So there is a good chance it will still be 15% + 6.85%

beltim

  • Magnum Stache
  • ******
  • Posts: 2848
What do you anticipate your capital gains tax rate to be when you eventually want the money (e.g. in retirement)?  Assume capital gains tax rates are unchanged between now and when you want to take the money out.

The question of the day... I can hope for 0% in which case it makes sense to hold out... but like MMM I will probably wind making money indefinitely even if I plan not to... So there is a good chance it will still be 15% + 6.85%

If the tax rate stays the same, then you're better off by the difference in expense ratios each year.  It's just the commutative property of multiplication.

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
What do you anticipate your capital gains tax rate to be when you eventually want the money (e.g. in retirement)?  Assume capital gains tax rates are unchanged between now and when you want to take the money out.
The question of the day... I can hope for 0% in which case it makes sense to hold out... but like MMM I will probably wind making money indefinitely even if I plan not to... So there is a good chance it will still be 15% + 6.85%

If the tax rate stays the same, then you're better off by the difference in expense ratios each year.  It's just the commutative property of multiplication.

Well that is the thing... You asked if tax rates stay the same... My hope is somewhere along the way I am going to get a lower cap gains tax rate, although that can bite hard if the tax laws change and 0% disappears before I do.

I can't say just like I can't say will the managed funds be worth the management fee... From my gut I have never liked managed funds, but looking at the results there have been extended periods of times (10 years), that these funds did out perform. I am disregarding the load which was before my wife and I were married, it might have been paid by her grandmother for all I know. So I am really only looking forward at this point.

The after expense returns look pretty equal as of now...

beltim

  • Magnum Stache
  • ******
  • Posts: 2848
One option would be to use these funds as your kids college funds - they inherit your cost basis, but once they turn 18 they should be able to sell at the 0 capital gains rate.

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
One option would be to use these funds as your kids college funds - they inherit your cost basis, but once they turn 18 they should be able to sell at the 0 capital gains rate.

Gifted assets retain their cost basis, my wife has stocks that her parents gave her, there is no step-up.

Regardless, with the kiddie tax they wouldn't get to sell until 23 anyway at 0% cap gains.

Only $2k at there rate, then my normal tax bracket not even capital gains rate...

beltim

  • Magnum Stache
  • ******
  • Posts: 2848
they inherit your cost basis,

Gifted assets retain their cost basis, my wife has stocks that her parents gave her, there is no step-up.

beltim

  • Magnum Stache
  • ******
  • Posts: 2848
However, good point about the kiddie tax.  I didn't think about that.  So it wouldn't work for college.

seattlecyclone

  • Walrus Stache
  • *******
  • Posts: 5064
  • Age: 35
  • Location: Seattle, WA
    • My blog
If you plan for your capital gains tax to remain the same forever, the best thing is to sell right now, because the expense ratio eats away at your capital if you hold, and the taxes will be roughly the same in the end anyway. Every day you continue to hold your expensive fund, you're falling behind what you could do if you switched.

If you plan for your capital gains tax rate to go to zero eventually, then you need to look at how much tax you will pay now versus how long you would take to make that money back in lower expense ratios. You would pay approximately 6.3% of the total value of your ABALX shares in taxes if you sold them right now. That's approximately equivalent to the expense ratio difference compounded over 12 years, so that's the breakeven point between selling today versus holding the expensive shares for 12 years and then selling tax-free. If you plan to be in the 0% capital gains bracket within 12 years, might make sense to hold the shares until then. Otherwise, sell now.

Repeat this calculation for your other funds. The other two funds have appreciated more, so the breakeven point is longer, so you may be less likely to do better by selling now.

NorCal

  • Pencil Stache
  • ****
  • Posts: 778
I would not sell now based some quick back of the envelope math.  Double check to be sure I read this right.

If I'm reading your table right, you're looking at a ~$7,500 tax hit in order to save a bit over $400/yr in expenses.

If you assume a compounded growth of 7%, you're earning about $525/year on that $7,500 that you would otherwise pay in taxes.

Assuming you're investing for 10 years+, here's my advice.  Wait for the next market crash.  I have no idea when this will happen.  Maybe it will happen in a decade, or maybe it will happen this year.  But whenever it does you can sell these funds for something much closer to your cost basis and reinvest in better funds.

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
If you plan for your capital gains tax to remain the same forever, the best thing is to sell right now, because the expense ratio eats away at your capital if you hold, and the taxes will be roughly the same in the end anyway. Every day you continue to hold your expensive fund, you're falling behind what you could do if you switched.

If you plan for your capital gains tax rate to go to zero eventually, then you need to look at how much tax you will pay now versus how long you would take to make that money back in lower expense ratios. You would pay approximately 6.3% of the total value of your ABALX shares in taxes if you sold them right now. That's approximately equivalent to the expense ratio difference compounded over 12 years, so that's the breakeven point between selling today versus holding the expensive shares for 12 years and then selling tax-free. If you plan to be in the 0% capital gains bracket within 12 years, might make sense to hold the shares until then. Otherwise, sell now.

Repeat this calculation for your other funds. The other two funds have appreciated more, so the breakeven point is longer, so you may be less likely to do better by selling now.

I don't imagine I will be in the 0% cap gains tax bracket within 12 years, I do however anticipate that I will generate tax losses over the next 12 years which can leveraged which can be used to balance out these gains.

beltim

  • Magnum Stache
  • ******
  • Posts: 2848
If you plan for your capital gains tax to remain the same forever, the best thing is to sell right now, because the expense ratio eats away at your capital if you hold, and the taxes will be roughly the same in the end anyway. Every day you continue to hold your expensive fund, you're falling behind what you could do if you switched.

If you plan for your capital gains tax rate to go to zero eventually, then you need to look at how much tax you will pay now versus how long you would take to make that money back in lower expense ratios. You would pay approximately 6.3% of the total value of your ABALX shares in taxes if you sold them right now. That's approximately equivalent to the expense ratio difference compounded over 12 years, so that's the breakeven point between selling today versus holding the expensive shares for 12 years and then selling tax-free. If you plan to be in the 0% capital gains bracket within 12 years, might make sense to hold the shares until then. Otherwise, sell now.

Repeat this calculation for your other funds. The other two funds have appreciated more, so the breakeven point is longer, so you may be less likely to do better by selling now.

I don't imagine I will be in the 0% cap gains tax bracket within 12 years, I do however anticipate that I will generate tax losses over the next 12 years which can leveraged which can be used to balance out these gains.

If the alternative use of capital losses is to offset salary, you'd be better off doing that because your marginal rate on salary is higher than your capital gains tax rate. 

Mister Fancypants

  • Bristles
  • ***
  • Posts: 296
  • Age: 42
  • Location: New York
If you plan for your capital gains tax to remain the same forever, the best thing is to sell right now, because the expense ratio eats away at your capital if you hold, and the taxes will be roughly the same in the end anyway. Every day you continue to hold your expensive fund, you're falling behind what you could do if you switched.

If you plan for your capital gains tax rate to go to zero eventually, then you need to look at how much tax you will pay now versus how long you would take to make that money back in lower expense ratios. You would pay approximately 6.3% of the total value of your ABALX shares in taxes if you sold them right now. That's approximately equivalent to the expense ratio difference compounded over 12 years, so that's the breakeven point between selling today versus holding the expensive shares for 12 years and then selling tax-free. If you plan to be in the 0% capital gains bracket within 12 years, might make sense to hold the shares until then. Otherwise, sell now.

Repeat this calculation for your other funds. The other two funds have appreciated more, so the breakeven point is longer, so you may be less likely to do better by selling now.

I don't imagine I will be in the 0% cap gains tax bracket within 12 years, I do however anticipate that I will generate tax losses over the next 12 years which can leveraged which can be used to balance out these gains.

If the alternative use of capital losses is to offset salary, you'd be better off doing that because your marginal rate on salary is higher than your capital gains tax rate.

Good point... I hate when people have good points :p