Pay Capital Gains Tax to transition to Passive Index?

[REattempt]

I'd like to get insight on how you would approach this situaton.

Over the last couple years of reading this board, I've learned a great deal. I have been restructuring my investments to low-cost, index, passive MFs/ETFs. I now have about 50% of my investments under self managment and another 50% that are still with my FA.

The remaining non-qualified assets with the FA have an Unrealized Capital Gain (99.5 long term) of about 200K. They are not in index/passive/Low-cost. To get these assets changed/moved, I would have to sell, realize the capital gains and pay the taxes. Federal and state taxes on the gain will be about 40K (ouch!)

Without this gain, I will be in the 25% tax bracket.

I really want to get this money transitioned. Do I just make the transition and forget the taxes? Do I do it over a period of time? (that would be a pain)

What do you folks suggest?

 

[Alan]

I really want to get this money transitioned. Do I just make the transition and forget the taxes? Do I do it over a period of time? (that would be a pain)

I would do it over time. You may get 'lucky' and after year 1 or 2 there is a major market downturn and your capital gain problem goes away.

Pick a period like 5 years and start the conversion.

 

[kaneohe]

and make sure you are not compounding the problem by automatic reinvesting in the high ER funds.........

perhaps this will help for the insight.....change the numbers to fit your situation and check the math: assume here current value of 500K

current value 500K; LTCG 200K (implies 300K basis)

case 1) sell, pay 40K tax (20% on 200K gain), left with 460K aftertax
reinvest in low ER funds w/ 460K basis; assume future gain of 7%/yr

case 2)do not sell, start (continue) w/500K high ER funds w/ 300K basis;
assume future gain of 6%/yr (1% higher ER)

create tables of multiplying factors for each growth rate for various time periods:

7%/yr gains

yr 1: 1.07x
yr 2: 1.145
yr 4: 1.3108
yr 8: 1.7182


6%/yr gains
yr 1: 1.06x
yr 2: 1.1236
yr 4: 1.2625
yr 8: 1.5939

Case 1) after 8 yrs, value is 790K (460x multiplying factor)
basis is 460; gain is 330; tax at 20% is 66
Aftertax value is 724

Case 2) after 8 yrs, value is 797 (500 x multiplying factor)
basis is 300, gain is 497, tax at 20% is 99
aftertax value is 698K

so in about 8 yrs (under these assumptions) the lower ER funds overtake the higher.
You'll have to consider any ill effects if you convert all at once......should not directly affect LTCG tax if limited to a single max % (like 15%) today but the higher AGI may affect deductions/credits/etc. Alan's phaseout suggestion has some merit.

Be aware that starting in 2013, there is the new Medicare tax on investment income
so if your LTCG goes too high, you will be affected:

Additional 3.8% tax on net investment income (including long-term capital gains and dividends) if adjusted gross income exceeds:

$200,000 (single).
$250,000 (married filing jointly).
$125,000 (married filing separately).

 

[RunningBum]

There are a couple of reasons you might want to do it over time:

1) If you die, your heirs get the stock at a new basis.

2) If you got down to the 15% bracket, cap gains (currently) are free, but only to the point where income+divs+CGs are under the 15% bracket. Since your sig says you are already retired, you might never be in the 15% bracket. This would also use up any room under the 15% point for Roth conversion, if you are doing it.

3) As Alan says, the market may drop and reduce eliminate your cap gains. However, it may also go up, and increase your cap gains.

4) The extra income could affect any Obamacare subsidy, but I'm doubting you'll be eligible for this.

At best the cap gains rate will stay the same in the future, but it might go higher. I don't think it's reasonable to expect them to go lower.

If you've decided to go for lower expense index funds (a good choice, IMO), I would just take the full cap gains hit now and get your investments where you want them to be.

 

[donheff]

7%/yr gains

yr 1: 1.07x
yr 2: 1.145
yr 4: 1.3108
yr 8: 1.7182


6%/yr gains
yr 1: 1.06x
yr 2: 1.1236
yr 4: 1.2625
yr 8: 1.5939

Case 1) after 8 yrs, value is 790K (460x multiplying factor)
basis is 460; gain is 330; tax at 20% is 66
Aftertax value is 724

Case 2) after 8 yrs, value is 797 (500 x multiplying factor)
basis is 300, gain is 497, tax at 20% is 99
aftertax value is 698K

so in about 8 yrs (under these assumptions) the lower ER funds overtake the higher.

On the break even point keep in mind that your basis for future CGs will be at today's prices so you need will need to assume an extra $40K in taxes when you sell the 6% portfolio.

 

[kaneohe]

On the break even point keep in mind that your basis for future CGs will be at today's prices so you need will need to assume an extra $40K in taxes when you sell the 6% portfolio.

isn't that accounted for in the different basis numbers for each case?

 

[donheff]

isn't that accounted for in the different basis numbers for each case?

Sorry -- I glanced at the top part and didn't account for your setting the basis separately.

 

[REattempt]

Oops, should have included the higher by 1% ER Fees and the +.8% FA Fees in my original post. Assuming a 1MM portfolio, this should save me 18K/year if I can transition faster. 2 year payback if I think about it that way...no?

 

[kaneohe]

yup.......yours is a much more intuitive way of looking at it esp since the tax actually a small part of the total (4%) . You might want to ask if you should do it in one swoop this yr or not at the fairmark.com forum (Cap gain subforum). Possible advantages:
15% CG vs possible higher in future, 3.8% Medicare tax on investment income in future, possible reduction of itemized deductions w/ higher AGI in future;
Possible disadvantages: ? might be missing something so would be good to get more eyes on it; AMT might be good to run your tax situation thru tax software or calculator http://turbotax.intuit.com/tax-tools/calculators/taxcaster/