This is a question that’s been on my mind for a while, partially out of curiosity and also because it’s been raised by readers a few times: Suppose you didn’t get the “memo” on passive investing early enough in your life and you now have some high-expense-ratio funds in our portfolio. So, is it too late to switch to a low-cost fund now? Maybe you’re lucky and your funds are actively-managed and they actually beat the broad index reliably. Good for you, but more often than not people are unhappy with the performance of their high-fee funds and like to switch to a low-fee, passively-managed index mutual fund at Fidelity, Schwab or Vanguard. Or move to one of the many index ETFs. Fees will be in the low single-digit basis points, around 0% to 0.015% for some of the Fidelity index funds and around 0.035% for the “Admiral Shares” Vanguard funds. Of course, if this is a fund in a tax-advantaged account where you can just switch between funds without any tax consequences you should just do so if you have that option. But the story gets a lot more complicated in a taxable account! We now have to weigh the pros and cons of switching to a low-cost fund:
Pro: You get rid of that “stinker” mutual fund and replace it with a low-fee, or even zero-fee index fund and eliminate the drag from the high expense ratio. We could be talking about a 0.5% difference in fees and maybe as much as 1.0 or 1.5%. And that’s every year! This can accumulate to a very large pile of cash over time!
Cons: You may have to realize capital gains today. There is a tax inefficiency from having to realize capital gains before you actually need the money in retirement. And this inefficiency takes two forms:
1) for most of you, there’s a good chance that marginal tax rates will be lower in the future, especially in retirement. Your high income right now might put you into a high marginal tax bracket (both Federal and State), while in retirement you might face much lower (or potentially zero) marginal rates. It’s best to defer capital gains until then!
2) even if your future projected tax rate is the same, there’s a potential inefficiency due to realizing capital gains twice; once today when switching to the new fund and once in the future when liquidating that fund in retirement, thus compounding the drag from taxes. It’s best to defer capital gains and pay taxes only once in retirement.
So, depending on how much in built-in capital gains you have right now, how much you can lower your expense ratio and what your current and projected future tax rates are, it may be optimal or suboptimal to dump that high-expense fund. In other words, it is the choice between two evils: The one evil is the drag from the high expense ratio and the other is the drag from tax inefficiency. Which one outweighs the other? Hard to tell, unless you put some numbers in a spreadsheet and do a proper “horse race.” And that’s what we do here today. Let’s take a look…
Oh, one more thing before we get to business today… make sure you check out this new FI/FIRE book, written by my great buddies Chris Mamula (Can I Retire Yet?) and Brad Barrett and Jonathan Mendonsa (ChooseFI), titled Choose FI: Your Blueprint to Financial Independence (affiliate link, please check the Disclaimers for more info). It’s a great source of information even for experienced FI planners. But I will also recommend this book to anyone who’s just starting out and wonders how to even get started! You start with -well – a blueprint, of course, and this is the best one out there. I can’t endorse this book more enthusiastically!
Clear-cut cases that probably don’t require any careful quantitative analysis
Before we get our hands dirty, let’s start with the two extreme cases where the decision to either switch to a new fund or stick with the old fund is pretty clear-cut and likely wouldn’t require much math:
Always replace your fund with a similar, low-cost fund if:
- It currently has a taxable loss or zero taxable gain! With a taxable loss, enjoy the benefit of Tax Loss Harvesting and the assurance that the tax inefficiency mentioned above doesn’t apply here. You only stand to gain from switching to the low-cost fund!
- You live in a zero-tax state and you’re in the lowest two Federal Tax brackets. You pay zero marginal tax on long-term gains right now. By the way: independent of the expense ratio, this might be a good time to “harvest” the capital gains in your fund anyway to increase your tax basis. There is still one caveat, of course: you may not have a true zero marginal tax if you’re receiving ACA/Obamacare subsidies!
- Just for the record again: if your high-expense-ratio fund resides in a tax-advantaged account (401k, 403b, 457, IRA, Roth, HSA, etc.), yes, then switch to a low-fee fund. If your current provider doesn’t offer anything with low fees, simply move your account to one that does (e.g., Fidelity, Schwab, Vanguard) if that’s possible. But of course, the remainder of this article is purely about taxable accounts!!!
Keep your high-expense ratio fund if:
- You like the fund’s performance and there’s no close substitute with a lower expense ratio. Hard to imagine, but possible!
- You have significant taxable gains and you have an unexpectedly high income in the current tax year that pushes you into the 15% or even 20% bracket on your Federal return and maybe even the extra 3.8% Obamacare tax. But you expect to be in a lower tax bracket in the not-too-distant future (ideally next year). At least defer the decision to move or not until the year with the lower marginal tax rate.
- You currently live in a high-income state (CA, OR, HI, NY, etc.) but you plan to move to a low-tax or no-tax state (TX, FL, NV, WA, etc.) in the near future.
Pro tip: If you decide to keep your fund, be it temporarily or permanently, you should at least disable the dividend and capital gains reinvestment into that fund. Instead, direct those flows into the new, low-fee mutual fund!
When things are not clear-cut… Get out that spreadsheet!
Unfortunately, the two extremes above are pretty rare. In practice, most people fall into that limbo state in between where you can’t draw a definitive conclusion without getting out a spreadsheet to determine the pros and cons of moving the fund.
Here’s the link to the Google Sheet: —> Google Sheet: “Should I sell my high-expense-ratio Fund?” <—
As always: You cannot edit the clean copy that I post on the web. I can’t allow everybody to alter the inputs and/or mess with the formulas. So, please, please, please, don’t contact me asking me for permission to edit my sheet. I won’t grant you access to my brokerage accounts either! 🙂
The fields that require your input are marked in dark orange:
- The current value of the shares and the cost basis of this lot. In this example, I assume that the shares are worth $10,000 and the cost basis is $4,000. Thus, if we wanted to move to a new fund, we’d realize $6,000 in (long-term) capital gains.
- The current annual expense ratio: 0.50% in this case.
- The new lower expense ratio: 0.015%, for example, Fidelity’s FSKAX
- The index capital gains and dividend yield expected values (5% and 2%, respectively). I assume in all examples that the two funds will deliver the same expected capital gains every year, but their dividend yield is reduced by the expense ratio. That’s how the fund companies normally pay themselves! So, for example, if the portfolio has a dividend yield of 2% and your two funds have a 0.500% and 0.015% expense ratio your dividend yield will be 1.5% and 1.985%, respectively.
- Again, if your specific example calls for something more complicated, feel free to override. For example it’s conceivable that your high-fee mutual fund also beats the index before fees, but maybe not after fees. Simply increase the expected cap gains of the old fund.
- The tax rates. We can input marginal tax rates for both dividends and (long-term) capital gains. They should be the same, but just in case there’s a state tax law somewhere that I might have missed I allow for a different rate. There’s also one quirky example below where you indeed set different rates, so stay tuned!
- I also allow there to be a change in your tax rates (to account for a move to a different location, moving up/down the tax brackets, etc.) and you can specify what year that change occurs. And feel free to just override the tax parameters in the calculations (columns B and C) if your personal situation calls for a more complicated path of tax rates than my 2-stage process! In this base case scenario, I assume that all tax rates stay at 20% (e.g., 15% Federal plus 5% State).
I look at two different scenarios:
Scenario 1: Sell the expensive fund and invest all the after-tax receipts into the new fund. In this base case scenario, you’d realize $6,000 in capital gains and thus pay 20% of that ($1,200) in taxes. You now have $8,800 in the new fund and a new cost basis in that same amount.
Scenario 2: Keep the old fund but direct all the dividend income in the new, low-fee fund. Needless to say, the dividends of the new fund are also reinvested in that same fund!
Also, notice that in both cases all dividend reinvestments are net of tax. So, there is no additional cash flow into or out of the portfolio which makes this a pretty simple “horse race;” we simply have to compare the final value net of taxes to see who wins!
For the spreadsheet wonks, in rows 39 and below, the Google Sheet tracks how the portfolio values evolve in the two scenarios (Scenario 1 = columns D-G, Scenario 2 = columns H-N). For every year between 1 and 40, I can then calculate what the final, after-tax net worth would be if you liquidate the portfolio in that year (Column G in scenario 1 and column N in scenario 2). The difference (column O = column G – column N) is then the advantage of selling the expensive fund relative to keeping it. Notice that for year 0, I will always have a zero advantage, by definition.
I also plot values of column N (the advantage of switching over time) in the time series chart, see below. What’s interesting about this base case scenario is that the decision switch vs. stay depends on the horizon. If you plan to finally liquidate your position between years 1 and 35 it wouldn’t be worthwhile to switch. The lower expense ratio can’t make up for the tax inefficiency cost of realizing capital gains both today and in the future while retired. In years 36 and onward, you do benefit from having switched funds in year zero, and that benefit increases rapidly because that high fee advantage now compounds very rapidly and easily exceeds the cost of the tax inefficiency.
You’d have to plug in your parameters because I can’t foresee and go through all the different cases that apply to everyone out there. But here are a few other case studies I’ve done and each case has its own tab in the Google Sheet:
Case 1: Higher Cost Basis
Let’s increase the cost basis to $8,000 while keeping all the other inputs the same. It’s now worthwhile to switch to the low-cost fund, regardless of your horizon. Makes sense: because the tax bill in year zero is small enough even a single year of lower fees – all else equal – makes up for that loss.
Case 2: Higher expense ratio
I was not too surprised to see that the results are extremely sensitive to the expense ratios! If I were to increase the E.R. of the existing fund by just 30 basis points to 0.8%, the results look totally different. It’s now (almost) a no brainer to switch to the low-fee fund. For a handful of years, you’d still be underwater but only by a very small amount. If you withdraw the money in year 5 or beyond, you’re better off switching to that lower-cost fund!
Case 3: Low future tax rates
Let’s assume that you plan to retire in year 5. You will end up in the lowest two federal tax brackets where long-term capital gains are not taxed but you still owe 5% marginal taxes in your state. So, we set the tax rates for the later period to 5%.
The lower tax rates in the future will shift down that curve significantly, meaning that it stays much more attractive to keep the bad fund if you’re planning to withdraw funds within the next 35 years. But even with the greatly reduced rate in the future, over a long enough horizon it is indeed best to switch! Starting at around year 20 or so, the curve starts bending upward and the compounded effect of lower fees will eventually outrun the tax efficiency effect in year 37!
Case 4: An Estate Planning Case Study
Do you want to know a great tax-saving strategy? Death! Yup, if you have a portfolio of appreciated assets with sizable capital gains, and after your death, your heir(s) take possession of the assets (e.g., stocks or real estate) the cost basis will be “stepped up” to the current fair market value. Thus, heirs can then sell the property right away and not owe any tax:
So, imagine you have aging parents or grandparents or an aunt or uncle who has a portfolio of funds with built-in gains. Don’t be too eager to take their portfolio to the woodshed! Your love for VTSAX may be appropriate for all you young savers in your ChooseFI Facebook group, but later in life, it may just be optimal to leave the money where it is.
So, here would be an example: 85-year-old Aunt Betsy has a highly appreciated fund with a 0.80% annual expense ratio. She’s subject to 20% taxes right now. She never really plans to sell this fund and just wants to keep this money for you, her favorite niece/nephew. Switching to FSKAX or VTSAX would be penny-wise and pound-foolish because the lower expense ratio can never recover the huge tax bill upfront. Upon her death, you can inherit the whole thing free and clear of any capital gains tax! Unless aunt Betsy lives for another 20+ years you’re better off just letting the bad fund run, and do the transition only after you become the owner and get the step-up basis, see below:
By the way, this is the one quirky case where the capital gains and dividend taxes differ in the spreadsheet. When you inherit the money in year T, you apply a 0% capital gains tax and that T could occur anytime after year zero. But along the way, Aunt Betsy is still paying a 20% tax on her regular dividend income. Hence, the dividend tax rate has to be 20% throughout, but I set the capital gains tax rate to 0% starting in year 1.
Side note 1: They say only two things are for sure; death and taxes. How ironic that the one sure thing – death – will greatly reduce or even eliminate the other.
Side note 2: I’m not an accountant, but to my knowledge, this step-up basis works not just when money is passed to the next generation(s) but even when passing property from one deceased spouse to the surviving spouse. See this article on MarketWatch.
Case 5: Higher/Lower Return expectations
Needless to say, changing the annual rate of capital gains will also impact results. Generally, you will find that:
- Higher capital gains growth (in both funds) will tip the scale towards staying(!) with the high-fee fund because the higher the capital gains growth the more severe is the inefficiency of the double taxation of gains.
- The flipside of the above is that lower capital gains growth will favor shifting to the low-expense-ratio fund.
Don’t believe me? Let’s look at two examples:
1: Raise the expected capital gains growth rate from 5% to 7% (while keeping the dividend yield at 2% less expense ratio). It will shift the curve down, meaning that no matter when you need the money over the next 40 years, it’s a bad idea to switch today.
2: Lower the expected capital gains growth rate from 5% to 3%. It will significantly raise the attractiveness of switching to the low-fee fund. The cross-over point is now at about 21 years, but even if you withdraw during years 1 through 20, the loss is negligible.
6: Actively-managed fund with capital gains distributions
One last example before this post gets too long! Another fly in the ointment of actively managed funds: by definition, there will be trading activity – buying and selling of stocks to (hopefully!) beat the index. But that’s a taxable event for you, the investor. How do I implement this? Long-term gains are taxed at the same rate as dividends, so I shift one percentage point of capital gains into the dividend column while leaving everything else the same. The yield is of the old fund is now 2% (index) – 0.5% (expense ratio) + 1% (capital gains distribution) = 2.5%.
Not surprisingly, this will dampen the attractiveness of the existing fund. The cross-over point is now at 27 years. No surprise here! The whole advantage of holding on to the high-fee fund came from the compounding of capital gains. Every percentage point we take away from that makes the status quo less attractive!
Side Note: There are ways to expand the complexity of this Sheet even more: Allow for short-term gains at a higher tax rate, but I don’t want to over-complicate everything in the first iteration. Maybe I’ll do an update on this later.
If you just recently found out about the FI/FIRE community and the benefits of low-cost, passive index investing, chances are you have some “skeletons” in your closet, in the form of those nasty high-fee funds. It may still be OK to switch to good ol’ VTSAX, but it’s also entirely possible that your past mistake is just that – it’s water under the bridge and it may be best to just keep that fund for a few more years until you need the money in retirement. There is a tradeoff between fee-efficiency and tax-efficiency! Whether the switch makes sense or not depends on a lot of parameters. There is no one-size-fits-all solution to this problem. Hard to come up even with a Rule of Thumb! My Google Sheet is a (first) attempt to shine some light.
Also, you’ll likely have to repeat this analysis for every tax lot in your account. So, it’s possible that for the tax lots with the really low cost basis you hold on to your old fund, but you liquidate the more recent tax lots; probably the more recent savings and dividend reinvestment!
Hope you found this helpful! Please leave your comments and suggestions below!
Title picture credit: Pixabay.com