Taxable Investment Account Sanity Check

[Nate_D]

Hey guys, I'm planning on making some pretty drastic changes with a taxable investment account I own and wanted to bounce my plan off y'all to make sure I'm not about to do something stupid.

A little background:
After aging into a trust set up by my grandparents, I gained ownership of an actively managed, taxable investment account at Morgan Stanley. It was invested in almost 100 US stocks, and I was getting hit with management fees of about 1.75% annually. Obviously the fee situation was not ideal, so I wanted to get out of the actively managed account and into index funds or ETFs. The only "problem" (if you can call it that) is that the account has about $110k of unrealized capital gains at this point, so if I simply sold everything and plowed the proceeds into a different investment, I'd be hit with a huge tax bill at the end of the year.

Another little wrinkle: I have about $34k in capital loss carryover from 2012, although the managed account already locked in about $4k of realized gain for the year, so I have about $30k left in carried-over loss.

So far, I have transferred all the shares in-kind to my brokerage account at Charles Schwab. So they are no longer being actively managed (so no management fees), but I still have a big bucket of 100 stocks to work with.

I'm having trouble deciding exactly how much stock I should sell (and how much gain I should lock in) for the year 2013. I know I'll sell at least enough to get $30k of capital gains (which would be cancelled out by the $30k carried over loss). What other practical considerations should I be making when deciding how much more to sell?

Financial stats:
--Married filing jointly, expecting to be in the 25% bracket
--$145k annual household W-2 income
--About $24.5k contributions to traditional 401(k), $10.5k to Roth 401(k) for 2013
--$11k Roth IRA contributions for 2013

Beyond the $30k in gains cancelled out by capital loss carryover, should I sell enough stock to lock in an additional $24.5k in gains, which would offset our before-tax 401(k) contributions and put us pretty close to the AGI barrier for the 28% bracket? I realize I'm not taking the standard deduction into account, but all these variables and what-ifs are making my head spin. Am I at least on the right track?

[dragoncar]

How closely do the 100 stocks approximate an index fund?  You may not track the index perfectly, but I'm guessing you have sufficient diversity and right now zero expense ratio!

[xocotl]

One thing that might be worth considering is that if you continue to carry over your loss, rather than cancelling it out by realizing gains, you can use it against $3k of regular income per year, which effectively saves you 25% (if that's your tax bracket) instead of the 15% you're saving by cancelling out capital gains (assuming they are long term gains). It all depends on how much you want to get out of those stocks into an index fund though.

[Nate_D]

Good points!

Regarding the account's allocation, it's all US equities: about 75% large cap growth and 25% small cap growth. At 100 stocks (as opposed to the hundreds or thousands in typical indexes) that seems way less diversified than any index I might consider following. However, in practice, it seems to have been roughly tracking the S&P 500, from a purely anecdotal perspective. If it makes a difference, I'm planning on leaving this account untouched (neither contributing to nor deducting from it) for the next 20 years. So I guess the question is, is the prospect of having to maintain this collection of stocks for 20 years worth the approx $14k tax hit I'd have to take up front if I moved into a set-it-and-forget-it index fund or ETF? I'm honestly not sure at this point, although $14k compounded over 20 years seems pretty substantial.

Regarding the capital loss carryover, that's another good point. Here the trade-off is extracting the most value out of my carryover vs. just getting it over with as soon as possible and getting out of stocks and into the ETF. If I decide I want to move to ETFs, I kind of want to avoid dragging the process out over several years.

[Nate_D]

Oh, and on top of the capital gains tax, it would cost me almost $900 in trade commissions just to sell all these freaking stocks. Ugh!

I want to reiterate that I certainly understand this is a good "problem" to have, all things considered, and obviously preferable to not having the account in the first place. I just wish my grandparents had followed the Boglehead school of investing instead of letting themselves get suckered by the financial industrial complex!

[daverobev]

I'd just leave them, if you are even remotely diversified. I mean, of the 100, multiplied by the $ value of the holding, what is your sector allocation like?

You might want to see if any of them have beneficial DRIPs - dividend re-investment plans. Often these will give a discount on shares bought by the dividend.

Bear in mind the headline index of many places is ~100 stocks or less - eg the FTSE 100, TSX 60, etc.

0.00% MER is better than anything, and if you're not (say) 80% financials... I'm sure you'll be ok.

[Nate_D]

Sector allocation is all over the place:

19.7% consumer discretionary
18.3% financials
15.7% information technology
13.1% health care
10.8% industrials
8.6% consumer staples
etc...

So at least I'm not loaded up in one particular sector.

I guess I'm just worried about what's going to happen to this portfolio over the course of 20 years or more. For example, my #2 holding by value is eBay. I wouldn't bet my life that their business model is going to hold up over the next decade, never mind 2 or 3. That's just one example, but there many other stocks in the portfolio that I have little to no understanding of. And I don't trust my abilities as a stock picker/seller. Do you really think I'd be okay letting these stocks ride for decades into the future?

[footenote]

Since you have an enormous time horizon, why don't you do the reverse of dollar-cost-averaging? Feather out of the positions either with a) a peanut-butter spread (1/20th of each sector each year) or b) reverse stock-picking. Or you could hybridize, liquidating the 1/20th of stock in each sector making you nervous.

(I too am not a stock picker, so I feel your pain. If I were you, I would probably feather out with the peanut-butter spread approach, 1/20th per year straight across sectors.)

[aj_yooper]

Congratualations!

I think you should transfer your assets to Vanguard (sorry) and take advantage of their investment advice.  They are the pros at indexing and I think, they would be the best advisers in this situation.  Don't sell anything now.  Use any tax loss carryovers to offset your current income.  Increase all of your tax sheltered investments to the max; personally, I would not be doing a Roth 401k as you will need deductions.  Max out your HSA if you have one.  Consider taking out a new mortgage to help with deductions.

I agree that it would have been great if grandpa had done Vanguard, but he may still have done well.  He was agile enough to build a longevity stash.  So take your time and study what you have.  Compare your holdings to the top holdings of the V Total Stock Market Index.  The best time to sell in a taxable account is never.  If you do sell a bunch, you will be blistered by taxes so be very careful.

[Nate_D]

@footenote: Good suggestion. My previous impulse had been to "rip the band-aid off" and get it over with as soon as reasonably possible, but I can see the benefit of reverse-DCA.

@aj_yooper: Thanks for the advice. We do have a Roth IRA with Vanguard so maybe we could still get some advice that way. We are indeed maxing out our retirement accounts...initially my wife was doing a Roth 401(k) but we have switched to traditional going forward.

Here's yet another wrinkle in our situation: we have about $50k in student loans at 6.5%. I have avoided using funds from the taxable account to pay them off because of the belief that, over the long haul, the stocks will compound at a rate greater than 6.5% and therefore they should stay in the market. Others have told me I should sell some stocks and take that 6.5% guaranteed return by paying off the loans. I'm on the fence with this one.

Sorry this has turned into such a multi-faceted debacle, but any advice on any of these questions would still be much appreciated!

[tomsang]

If you are paying an annual 1.75% of Assets Under Management fee, then I think you are right to look into this.  A big question, which you may not be willing to say is how much is the total assets under management?  If you have a million dollars then you are paying $17,500 a year in fees vs. $2,000+- at Vanguard, then you are getting slaughtered.  This analysis I believe will show that it is a pretty easy decisions to rip off the bandage vs. getting slowly boiled, take the hit and move the stuff to low cost. 

Other thoughts/choices.

1) Sell off and move all assets with minimal gains.  Liquidate the account, but leave enough securities to equal the $70k of gains or whatever you are comfortable with.

2) Call up your broker and say that you are not paying 1.75% that you are planning on moving them to Vanguard.  If he wants to keep the account he needs to come up with a better rate.  They can easily drop it to .8% if you have a sizable asset base.  If the amount is significant, I would still move the account.

3) Not being a psychic, I would not be surprised to see capital gains increase by 10-20% in the coming years.  I would lock in the low tax rate today and move everything tomorrow.

4) If the account is not significant, which I can't see how it wouldn't be with $110,000 of gains, then you could negotiate a lower fee, when stocks are sold to rebalance cut a check and move the funds out of the account slowly. 

Good luck, nice problem to have!!

Tom 

[aj_yooper]

A question:   If you aged into a trust, why would you have capital gains or losses? 

A totally different example:  If you inherited money, your capital basis is at the time of the transfer of assets.  Are you sure your trust is different in terms of capital gains or losses? 

[Nate_D]

@tomsang: Total value of the portfolio is about $240k. And I've already transferred the shares in kind to another brokerage, so they are no longer under management. The question now is what to do with all those shares: take the tax/commission hit and move to ETFs (and/or pay off student loans at 6.5%) or leave it alone and let the portfolio ride as-is. Good point on the possibility of the cap gains tax rising at some point.

@aj_yooper: For assets acquired by trust, the basis carries over/is unchanged. I had an accountant do my taxes the year I aged into the trust, just to make sure I wasn't missing anything.

[aj_yooper]

Good going on researching the trust, but sucks about the tax aspect. 

Oh, and on top of the capital gains tax, it would cost me almost $900 in trade commissions just to sell all these freaking stocks. Ugh!

I want to reiterate that I certainly understand this is a good "problem" to have, all things considered, and obviously preferable to not having the account in the first place. I just wish my grandparents had followed the Boglehead school of investing instead of letting themselves get suckered by the financial industrial complex!

I suspect it would be cheaper at Vanguard. 

$50,000–$500,000 level
(Voyager Services®)
Free trades of ETFs
All trades: $7

So, after studying your portfolio-setting up a spread sheet showing the basis P/E, and current price, I would arrange a consultation with a CFP at Vanguard and see what they would recommend re converting all/most/some of your trust assets to index funds and timing the sales. 

If you have plans for children or are a parent already, some of the money could be placed in a 529 plan, which grows tax free.  Unfortunately, they are funded with cash.

[tomsang]

If the student loans qualify for the $2,500 tax benefit then I would leave them as is. If they don't qualify, then I think an argument could be made to pay them off.

I would think that a 100 companies would be a fairly diversified portfolio. If you are not paying any fees, then you would be lower than Vanguard. You can sell off particular stocks, pay the commission and still be in great shape. 

Still shocked that your gain is such a high as a percentage of the portfolio.

Very nice Stache.

[fiveoclockshadow]

I've read more than one place (maybe Bernstien or Swedroe books) that in an equity asset class most volatility is reduced holding only 20 stocks. So you likely won't have a volatility issue.

What you may have is tracking error, which means over the short term your portfolio will diverge for periods of a few years from an appropriate index even though its long term return and standard deviation may be the same as the broader index. This is just a psychological thing (or if you are a fund manager a way to get a bonus or fired).

As to EBay or any other stock tanking that's what happens in a total market fund. In fact the only way issues leave the fund is when they go bankrupt, merge or go private. For long term holding stock price is technically irrelevant and the stock is assumed to go to zero with total return being just the sum of all the dividends and their reinvestment.  It feels different when you hold the stock in your portfolio and watch it, but in a fund multiple issues go to zero each year as well but you don't notice it happened.

So I'd say you could leave these for as long as you choose and perhaps just each year decide based on taxes what to sell and move to an index fund. They are equities, you will have losses to harvest at some point for sure. Taking a big capital gain now to move one diversified portfolio to another isn't at all optimal. You solved the major problem already, the management fee.

[dragoncar]

I've read more than one place (maybe Bernstien or Swedroe books) that in an equity asset class most volatility is reduced holding only 20 stocks. So you likely won't have a volatility issue.

What you may have is tracking error, which means over the short term your portfolio will diverge for periods of a few years from an appropriate index even though its long term return and standard deviation may be the same as the broader index. This is just a psychological thing (or if you are a fund manager a way to get a bonus or fired).

As to EBay or any other stock tanking that's what happens in a total market fund. In fact the only way issues leave the fund is when they go bankrupt, merge or go private. For long term holding stock price is technically irrelevant and the stock is assumed to go to zero with total return being just the sum of all the dividends and their reinvestment.  It feels different when you hold the stock in your portfolio and watch it, but in a fund multiple issues go to zero each year as well but you don't notice it happened.

So I'd say you could leave these for as long as you choose and perhaps just each year decide based on taxes what to sell and move to an index fund. They are equities, you will have losses to harvest at some point for sure. Taking a big capital gain now to move one diversified portfolio to another isn't at all optimal. You solved the major problem already, the management fee.

Agree Exxon and apple are both almost 3% of s&p.  what percentage of your holdings are eBay?  I think you can probably leave it for now.

For commissions, find a brokerage that will give you 250 free trades or whatever for opening an account.  Many will give you a few hundred in cash money for transferring that amount of assets.  Or ask Schwab for some free trades given your recent large influx.  Something like this;

http://investorjunkie.com/15929/charles-schwab-promotion/#charles-schwab-600signup

[Nate_D]

@tomsang: We should be able to do the full student loan interest deduction this year, and that does make a good case for not using stock sale proceeds to pay them all down. Thanks for the perspective.

@fiveoclockshadow: Good analysis...definitely food for thought.

@dragoncar: eBay is 3.4% of the portfolio. The biggest single component is Home Depot at 3.5%. So yeah, no one stock seems to be outrageously overweighted at this point.

Thanks for the input, everyone!

[Freeyourchains2]

If they are mostly dividend growth stocks, I wouldn't sell any of them, just collect the long term dividends and retire early (once your expenses are down around $23k/family of 4).

Once you are dead, and pass on the inheritance, IF you children decided to collect the Capital Gains, then they are only taxed from the day of the inheritances's cost basis, not before.

(Hopefully by then Capital Gains Tax is 0% and all the freeloaders are off of the Government Dime and working hard, and no more tax payer money is being handed out to Foreign enemies along with weapons.)

[simonsez]

We should be able to do the full student loan interest deduction this year

Maybe, I don't know how 145k in W-2 income will translate to MAGI in your situation but if that number is still over 125k MAGI, you won't have access to the full student loan interest deduction.  Good luck!

Scroll down to Table 4.2 and the other info below it about the phaseout just in case it applies.
http://www.irs.gov/publications/p970/ch04.html

[SunshineGirl]

Personally, I would find this a very fun problem to have! It's good you worked with an accountant, and you can always schedule a consultation to go over things before you take any action.

Are these like 100 stocks with $1-2,000 to each?

Anyway, if you do decide to keep all/some of them, most libraries have the Value Line Investment Survey, which is a fantastic research tool. Honestly, if Value Line tells me a company is solid, I believe them. They also do industry analysis. You could delve into it and come up with a decent list of keepers vs. get-rid-ofs. If your library doesn't have a copy, it's worth the subscription price. 

I'm also hooked on a blog written by Joshua Kennon -- joshuakennon.com - a very interesting guy who invests in individual stocks. You can learn a ton from reading his blog.