Unrealized gains in unwanted mutual funds

[Mister Fancypants]

So I was hoping to get some advice from MMM investment community....

Tell me what you think I should do...

My wife owns 3 American funds in a taxable brokerage account, she has owned them since before we met. These funds have not performed poorly but the expense ratio is high and we would rather not own them as there are cheaper investments in each asset class or the funds can be allocated to other investment opportunities. However since they have been owned for a long time and there have been lots of reinvested dividends and capital gains, there is a fairly substantial unrealized gain that has accrued.

We live in NYS so the combined federal and state tax rate on these gains is 15% (Fed) + 6.85% (NYS) = 21.85%

My dilema is do I keep the expensive mutual funds or sell them and pay the taxes, we have no short or long term losses to offset the gains.

I will provide all of the financials below, but the total value of the 3 funds is ~$62k, the taxes would be about $3.5k or 5.7% of the funds value. I don't think even with the high expense ratio's that the funds will underperform by 5.7% in any given short period of time, but with compounding and the fact that they have already been owned for a long period I'm not sure if the one time hit is worth it.

The American Funds are A shares which were front loaded and my wife paid for that at time of purchase, I can't cry over spilled milk, that was years before we met so the load is a sunk cost and has no bearing on the current problem, so please only focus on the continued ownership vs tax issue as the load paid no longer matters.

Thanks,
-Jay

Fund	Cost Basis	Market Value	Gain	Fed Tax	State Tax
ANWPX	$4,736.13	$7,242.51	$2,506.38	$375.96	$171.69
ABALX	$14,960.17	$18,319.47	$3,359.30	$503.90	$230.11
AGTHX	$26,579.33	$37,009.31	$10,429.98	$1,564.50	$714.45

[Numbers Man]

The key is to make sure that your cost basis is calculated correctly. Your spouse has been paying capital gains and has received dividends every year since she has held the mutual fund (check out the paperwork of your previous years tax returns). So your cost would be the actual cost of the mutual fund shares plus brokerage commissions plus reinvested dividends plus reinvested net capital gains.

You might consider having an experienced tax pro guide you through the mechanics of this calculation. You may find that you owe less taxes than you think.

[Mister Fancypants]

I have gone through all of the old brokerage statements and record the reinvestment prices for all of the dividends and capital gains, unfortunately the tax calculation is correct.

Thanks,
-Jay

[livetogive]

I'm relatively young so the right call for me was to sell the bad stuff, pay the taxes, move on.  Here's how I got there:

1.  If you havne't already, turn off automatic reinvestment of dividends and capital gains.  This will help you later with taxes.
2.  how handy in excel are you?  The way I did it was assume an 8% annualized index fund return and a 7.5% annualized expensive fund return.  I made one column of doing nothing and letting the expensive fund accrue 7.5% then subtract the maintenance fee until i expected to withdraw it (old school retirement I think?).  The second column(s) took the money out less the taxes then compounded it annually at 8%.  Made sense for me to take the 15% cap gains hit and pull out now, but your higher state tax rate might change that.

[Mister Fancypants]

Automatic reinvestments have been off for some time, so the current income is redirected elsewhere already.

I'm a software engineer, my excel is excellent :)

The returns haven't been that bad in some years they have outperformed the indexes, so you returns of being off by an annulized .5% is academic, I provided the tickers, the real world returns and expense ratios are available.

But just for arguments sake, if you take $62k in funds sell them and pay $3500 in taxes, it takes the remaining $58.5k @ 8% 13 years to catch up to the original $62k @ 7.5%... That is way too long to break even on the taxes...

The problem is future performance is unknown if the mutual funds perform close enough then the tax hit is not worth it, if they out perform then it definitely is not worth it, however if the start to seriously lag the the tax hit is the cost of doing business.

I of course can always wait and see and if/when performance starts to lag pull the trigger, but I am hoping someone might have a more compelling argument one way or the other...

Thanks,
-Jay

[livetogive]

I chose 7.5% to be nice,  but in reality it's probably lower due to taxes from fund manager churn.

If your fund is "outperforming"  the index I'm willing to bet the Beta is higher than 1, meaning your manager is taking outsized risks to make the return relative to a less risky benchmark.

13 years to break even is tough but I might do it anyway.  Either way I'd wait a year until the reinvestment capital gains are long term.

You can also do the calculation faster by just solving for n in excel.   This let's you make a data table or do some sensitivity analysis to see with what returns it would make sense.   So I might assume an r of between 6 and 8 with a sigma of 15 for stock market returns.   It's just too hard to tell on the intrawebs how comfy someone is with the program so I try to explain things the long way.

Alternatively you can wait for a bad investment year or a year with low tax implications (moving,  job switch,  FIRE,  whatever)  and do it then.   Cheers and good luck!

[KingCoin]

But just for arguments sake, if you take $62k in funds sell them and pay $3500 in taxes, it takes the remaining $58.5k @ 8% 13 years to catch up to the original $62k @ 7.5%... That is way too long to break even on the taxes...

But your tax liability will be bigger on the 62k than the 58.5k, so the 13yr breakeven isn't really fair.

Add to that the fact that taxes are at a historical low and are probably more likely to rise than fall in the future.  What if the capital gains tax is 30% or 50% down the road? Add some reasonable probability distribution to the forward tax rate, and I think you'll see that taking a tax hit now isn't such a crazy idea.

[Mister Fancypants]

KingCoin... You bring up a good point, taxes are at historic lows

Over the long term the poor expense ratio and the inevitable under performance of active management this is a poor investment vehicle, which I am going to want to divest at some point regardless. The longer I hold it the more the unrealized gains will add up and the higher the tax burden will be regardless of the performance under at or above market.

I will likely wait until 2014 to trade the funds so I can reinvest the entire amount, in 2013 it is too late I would need to use the proceeds to pay the taxes, I can plan for the taxes and use free cash flow from other income sources...

Sadly I don't have a single tax lot that is a lose to harvest...
 

[beltim]

Sadly I don't have a single tax lot that is a lose to harvest...

This is never a bad thing.  Not having losses means you have only profits!

As a Mustachian, I would ask you what your expected taxes in retirement are.  If they're going to be lower than your marginal tax rate now (and if your tax on long term capital gains is 15%, that means your federal income tax bracket is 25%), you could profit even more by waiting to sell until retirement, when your income is lower and your long term capital gains tax rate is 0%.

[Mister Fancypants]

I anticipate having earned income that would put me in the 25% tax bracket for about the next decade at least.

That is too far out to predict tax policy, I don't imagine taxes will remain this low, so even though my income might be lower in the future there is not guarantee that my tax rate will be lower in retirement.

I won't bet on the government working in my favor, too much bloat in Washington to really fix anything, so I anticipate higher taxes in the future regardless of income... Plan for the worst, hope for the best... It's out of my control unless I run for office so I just work within whatever tax environment exists at any given time

-Jay

[beltim]

Well, if you don't want to consider tax rates then I'd just consider which is the better investment.  I think too often people let the tail (taxes) wag the dog (investment return).  In this case, these funds have spanked the market over the last decade and more, so the question if whether you think it will continue.  They're below-average risk, so the higher return isn't a function of higher beta as TurboLT suggested.

[Mister Fancypants]

Sorry if I wasn't clear, I simply meant I think there is a good chance that my tax bracket of 25% now while earning high income might still be 25% under a more restrictive tax policy in the future even with a lower income while in retirement.

I don't really anticipate my tax rate ever going down, of course that is just speculation and I would love to be wrong.

-Jay

[Numbers Man]

If you are unhappy with the performance of those mutual funds, then sell and reinvest into a better choice. Even if it means paying the taxes.

Possible avenues to mitigate the current tax obligation is to fully fund the 401k or HSA if you have one. Also, you can accelerate a house payment or two before year end to capture more interest expense into this year.

[beltim]

Also, you can accelerate a house payment or two before year end to capture more interest expense into this year.

No you can't.  Paying more on your mortgage can only reduce the amount of interest you pay.

[beltim]

If you are unhappy with the performance of those mutual funds, then sell and reinvest into a better choice. Even if it means paying the taxes.

This is really the crux of it.  If you think these funds will beat the alternative investments, keep them.  If you think alternative investments will do well enough to overcome the tax advantage, then sell your current funds and buy the alternates.

[Numbers Man]

beltim - You need to brush up on your tax knowledge. Accelerating a house payment, i.e., making 13 to 14 payments in a year versus the typical 12 in a year will yield additional mortgage interest dollars on Schedule A. These additional dollars will increase your deductions which in turn will decrease your taxable income.

[beltim]

beltim - You need to brush up on your tax knowledge. Accelerating a house payment, i.e., making 13 to 14 payments in a year versus the typical 12 in a year will yield additional mortgage interest dollars on Schedule A. These additional dollars will increase your deductions which in turn will decrease your taxable income.

Please stop giving incorrect tax advice.  Only the interest portion of a mortgage payment is tax deductible.  See IRS Publication 936 (http://www.irs.gov/publications/p936/ar02.html)

[Numbers Man]

beltim - I'm not going to get into a pissing match with you. But if you reread my post it says in part "will yield additional mortgage interest dollars on Schedule A".

[beltim]

Okay, so you agree that only mortgage interest is deductible.  Then how could making more house payments reduce the interest you pay?  Every US mortgage I've ever seen applies extra payments to principal, and recalculates the interest for the next payment based on the reduced principal.  That would lead to paying less in interest.

(Which, by the way, is a good thing.  It just doesn't reduce your tax burden any)

[Mister Fancypants]

Everyone calm down.... This topic has nothing to do with mortgage interest deductions.

Besides the fact I already over pay my mortgage by 20% every month, and to the other comment earlier my 401k is also maxed.

For the record, I could pay my mortgage off in full, I would still owe the $3500 in taxes if I sold these mutual funds, so an extra payment isn't going to help me.

[beltim]

So have you decided on your course of action?

[Mister Fancypants]

Yes several posts back... I'm going to sell in 2014, as the gains will continue to grow and the future tax burden will be higher regardless if tax rates.

It was in response to KingCoins post.

Thanks,
-Jay