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Tax consequences of funds
Old 09-01-2009, 03:48 PM   #1
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Tax consequences of funds

When you hold funds (not individual stocks) in a TAXED portfolio in different asset classes, (large cap, mid cap, small cap, reits, international, bonds, cash) and you need to rebalance you really canít do any tax harvesting like you do with individual stocks, where you can sell a losing stock along with a winning stock, and replace both stocks without tax consequences.

With funds, you would be forced to sell that portion of the fund that has increased to replenish the fund that is lagging to try and keep your percentage allocation in tack. This would trigger paying taxes on the amount you have to sell, and increasing your taxes and tax bracket by the amount you sell. Is this a correct analogy? Is there any way around this other than owning individual stocks. What am I missing?
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Old 09-01-2009, 04:50 PM   #2
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I don't think you got it quite right.

First, rebalancing between asset classes is the same whether you hold funds or stocks. And that is not the same as tax-loss harvesting.

Second, tax-loss harvesting is the same whether you hold funds or stocks. And that is not the same as rebalancing.

With tax-loss harvesting, you sell something at a loss in a taxable account. Let's say is it EEM or PFE. Then you use the proceeds to buy something similar (in the same asset class), but not substantially identical. Let's say you buy VWO or MRK, respectively. Your asset allocation does not change.

With rebalancing, you sell something (doesn't matter for this purpose whether at a gain or loss) in one asset class, in order to reduce your weight in that asset class and buy something in a different asset class in order to increase your weight in that asset class.

For instance, you have too much US large cap stocks in your asset allocation and not enough foreign stocks, so you sell SPY or MRK and buy VEU or TEVA.
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Old 09-01-2009, 05:19 PM   #3
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I don't think you got it quite right.

With re balancing, you sell something (doesn't matter for this purpose whether at a gain or loss) in one asset class, in order to reduce your weight in that asset class and buy something in a different asset class in order to increase your weight in that asset class.

For instance, you have too much US large cap stocks in your asset allocation and not enough foreign stocks, so you sell SPY or MRK and buy VEU or TEVA.
Now, if it is a taxable account you just wouldn't re balance at all. Right?
Or maybe add new money to re balance?

Seems like if you have a mostly taxable account, you basically never sale your stocks. Right? If you are one of the more conservative folks with only 25/30% socks? Total stock fund? Retired and soon to draw income from portfolio?
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Old 09-01-2009, 05:45 PM   #4
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OK, then rebalancing funds. Let's say 3 funds are up and four are down, and I want to sell some of the 3 funds that are up in order to balance out my funds that are down. (This would be in addition to the money I need to take out to live on)

Example in point. $1,000,000 portfolio yields $60,000 ($25,000 in dividends and interest) and $35,000 in growth. I only need to take out $30,000 for personal use, so I take out the $25,000 in dividends/interest, $5,000 from one of the growing funds, but then if I want to rebalance my portfolio with the remaining $35,000, I would have to sell the gaining fund in order to fund the underperforming fund, and thus have to pay income taxes on $60,000 as opposed to only the $30,000 I need.
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Old 09-01-2009, 06:05 PM   #5
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What? You should not rebalance because of a mere 6% change in assets if it is even 6%.

Also you would not pay income taxes on $60K because most of the $60K would be return-of-capital which would be tax-free. So you figure out your capital gains, offset those with all those capital losses that you have carried over since 2000-2002 and 2007-2009. And when you do all that, guess what? NO TAXES!

Anyways, haven't you rebalanced before? Say in March 2000? Or in March 2009? What was that like?

Also some folks would only rebalance every 4 years or so.
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Old 09-01-2009, 06:26 PM   #6
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Now, if it is a taxable account you just wouldn't re balance at all. Right?
Or maybe add new money to re balance?

Seems like if you have a mostly taxable account, you basically never sale your stocks. Right? If you are one of the more conservative folks with only 25/30% socks? Total stock fund? Retired and soon to draw income from portfolio?
Steve
If you are one of the more conservative folks with 25/30% stocks, then dividends from your fixed income investments and stocks should pay for your expenses.

If your stocks/funds had a loss, you would tax-loss harvest regardless.

I don't know for sure, but with such a low amount in equities, I would guess that having to sell for rebalancing purposes would be rare because you would probably would not sell until they got to 35% of assets. Any capital gains would be offset by all those carryover losses that you have built up.
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Old 09-01-2009, 07:34 PM   #7
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Example in point. $1,000,000 portfolio yields $60,000 ($25,000 in dividends and interest) and $35,000 in growth. I only need to take out $30,000 for personal use, so I take out the $25,000 in dividends/interest, $5,000 from one of the growing funds, but then if I want to rebalance my portfolio with the remaining $35,000, I would have to sell the gaining fund in order to fund the underperforming fund, and thus have to pay income taxes on $60,000 as opposed to only the $30,000 I need.
I'd probably wait a little longer to rebalance, as LOL said. But I think your point is valid. Rebalancing involves selling positions that have outperformed and buying those that have underperformed. So in a taxable account, rebalancing will trigger gains taxes (if you're lucky enough to have gains).

But the same is also true for individual stocks.

Another minor quibble. You wouldn't pay taxes on the entire $30,000 needed to rebalance, only the portion of that $30K that represents realized gains.
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Old 09-01-2009, 07:36 PM   #8
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The biggest tax consequence of owning mutual funds versus stocks is that funds pay distributions annually which are taxable. With stocks, you have a little more control over the situation - unless the stock pays dividends, there is no taxable income from the stock until you sell it for a gain.

Otherwise, in terms of rebalancing or tax-loss harvesting they are the same, just like LOL! said.

I rebalanced early last month because my equity % had gone from 55% to 60%. And guess what - NO TAXES, because my average basis on enough funds was still below where I bought in.

Same thing last year when I sold bond funds to buy equities. Because bond funds pay out their dividend income monthly/quarterly, they usually don't show much in terms of capital gains. Or perhaps it was because most of my bond funds had a slight drop in NAV during the panics of last year. Whatever. Anyway it meant no taxable consequences for my rebalancings last year either.

I did have plenty of mutual fund distributions last year, however, and these were all taxable. I was able to do some tax-loss harvesting to offset this last year when I sold some of one balanced fund (at a loss) to put into a different balanced fund.

One thing people do to minimize tax consequences of mutual fund distributions, is to take all distributions in cash (i.e. don't automatically reinvest them). Then at the end of the year pay the taxes due on these, take the rest for the annual withdrawal. And only then, if needed, sell some of the higher performer funds to cover the remainder of the withdrawal.

And again - when you sell part of a mutual fund you only pay taxes on the gain, not on the total amount.

Audrey
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Old 09-01-2009, 07:42 PM   #9
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The biggest tax consequence of owning mutual funds versus stocks is that funds pay distributions annually which are taxable.
Good point. The dividend distributions are fine, but those capital gains distributions stink. I used the recent market unpleasantness as an opportunity to swap Vanguard's International Explorer fund for another international fund because Explorer is such a tax pig. The turnover is so high they end up paying out 100% of gains, sheesh.

Just one more reason to favor index funds.
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Old 09-01-2009, 08:36 PM   #10
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What really burns me up is capital gains distributions triggered by redemptions, due to panicked retail investors fleeing in a bear market meltdown.

I saw this happen in 2000, and again 2008.

I suppose even index funds will show some cap gains dists due to excessive redemptions.

A silver lining is that the mutual funds then have cap gain losses on their books that offset future gains. Looks like after 2002, cap gains dists were really muted for a couple of years. We can probably expect same in 2009, 2010.

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Old 09-02-2009, 09:53 AM   #11
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If you what something easy you can go with the Vanguard Target Retirement funds. They do the rebalancing for you and by looking at the yield this will give you a pallpark idea of the taxes due at the end of the year.
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Old 09-02-2009, 10:03 AM   #12
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If you what something easy you can go with the Vanguard Target Retirement funds. They do the rebalancing for you and by looking at the yield this will give you a pallpark idea of the taxes due at the end of the year.
Those are not considered very tax efficient and are better held in your tax deferred space. Also as a fund of funds you cannot tax lost harvest.

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Old 09-02-2009, 10:50 AM   #13
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True, but I am in the 15% bracket, so they work good in that bracket.
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Old 09-02-2009, 11:00 AM   #14
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....
Also as a fund of funds you cannot tax lost harvest.

DD
Are you sure about that? Help me understand if this is true by pointing to a link or something, thanks!
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Old 09-02-2009, 11:04 AM   #15
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If you what something easy you can go with the Vanguard Target Retirement funds. They do the rebalancing for you and by looking at the yield this will give you a pallpark idea of the taxes due at the end of the year.
I don't think the yield includes cap gains distributions - am I wrong? You will incur taxes on those too.

Audrey
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Old 09-02-2009, 11:19 AM   #16
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I think someone else said this in a way... but I will be more specific...

IF the laggards have a loss, you can sell them and buy a similar fund for the rebalancing so you can tax loss harvest..

Now, if they have a gain, but just are lagging, then this is not an option... just like if you do not have any stocks with losses, you can not create some..
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Old 09-02-2009, 04:51 PM   #17
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Those are not considered very tax efficient and are better held in your tax deferred space. Also as a fund of funds you cannot tax lost harvest.

DD
Good point about the tax lost harvesting looks like indexing wins again.
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Old 09-02-2009, 06:39 PM   #18
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OK, guys, you cleared up my head. I don't know these things cause I bought stocks for the first time this past year (lump sum-just before the crash) Lucky me.

And now I'm trying to get my head around re-balancing. I was forgetting that when you sell a portion of the gaining fund, you are only paying tax on the gain of your origianal bases.

As far as selling the whole fund when there is a loss and replacing with a similar type fund, in order to create a tax harvest loss to offset a gain, do many of you do this with funds? Also, how often would you rebalance in a taxable account?
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Old 09-02-2009, 07:41 PM   #19
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Sure - I've done it with funds several times. When we have a bear market which sometimes produces a net loss in a given fund, I take the opportunity to "upgrade" my portfolio - i.e. replace a fund with another that i think is better quality or better managed or lower cost or whatever. I did this in 2002, and I did this last year as well.

As far as rebalancing frequency - one study I read came up with 18 months as the optimal interval for a taxable portfolio. Practically speaking rebalancing in January is usually desirable because that's when you usually withdraw from the portfolio as well as deal with the distributions paid out in the previous December and figure taxes on the portfolio.

Personally I use a deviation from target of 10%. So if my equity allocation goes from 55% to 60% I rebalance back to 55%. Or when my REIT allocation goes from 5% of equities to 5.5%, I rebalance back to 5%.

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Old 09-02-2009, 08:59 PM   #20
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Taxes paid now reduces your taxes paid later, perhaps at a higher capital gains rate. So it's not critical to avoid taxes all the time. Rebalancing by adding new money to funds that are low or withdrawing from funds that are high is probably better. If you can rebalance the combined portfolio using funds within a retirement account (IRA) that's good. Or many papers have suggested never rebalancing taxable accounts. I don't like that as much.

I rebalance with a 20% trigger for each fund balance, whenever necessary. So I will rebalance from 6% back to 5% for Audrey's REIT case. That was optimum according to some paper I read long ago.

I have tax harvested with funds, sometimes moving into a similar ETF temporarily.
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