Transitioning from active to index mutual funds

[Canoeboy]

I currently have a mix of actively managed and index (passive) mutual funds in a reasonably diverse portfolio. Am looking to shift the bulk of the actively managed funds to index funds in order to reduce management fees. Given the recent market downturn and volatility, I have concerns about the timing of making this transition. Not planning to change % of asset classes. Should I be concerned? Would appreciate thoughts on how to best minimize risk in executing this transition.

I’m retired and all holdings (401k, IRA’s, Roth’s, taxable) are held under Vanguard.

 

[VanWinkle]

If the managed funds are down due to the current bear market, it would be a great time to tax loss harvest and reinvest into index funds. The taxable account is the only concern. The tax deferred/free accounts you can make the changes without any tax consequences. Congrats on a decision to reduce expenses. It is one of the best ways to increase returns with the same allocation.

If you have large capital gains in the managed funds, unwind them slowly paying attention to tax consequences in the taxable account.

 

[TheWizard]

As VW says, now is a good time for that transition, depending on your mix of capital gains and capital losses in the funds you hold...

 

[OldShooter]

If the managed funds are down due to the current bear market, it would be a great time to tax loss harvest and reinvest into index funds. The taxable account is the only concern. The tax deferred/free accounts you can make the changes without any tax consequences. Congrats on a decision to reduce expenses. It is one of the best ways to increase returns with the same allocation.

If you have large capital gains in the managed funds, unwind them slowly paying attention to tax consequences in the taxable account.

This.

Regarding timing, you are moving from the market to the market, so the level of the market really doesn't matter. You'll be out for a day or two as your sells settle, but just ignore any wiggles. In the long term you will not remember them anyway.

In fact, a lower market is your friend on the sell side -- lower profits to pay taxes on and larger tax losses to take. On the buy side, you're buying stocks on sale. Be happy.

On the equity side, one or two, at most three total market funds will do it. The only real question is how much international exposure you want. With the current strong dollar, remember that non-US funds are effectively selling at a discount.

 

[Canoeboy]

Thanks for the quick responses. My taxable account is of little concern as few equities remain there. Harvested all gains there over past few years to fund expenses in years 2-4 of retirement while putting us in the 0% federal tax rate and staying just under the 400% poverty rate for ACA subsidy purposes. That party is over in 2022, but the ACA subsidy cliff is temporarily on hold. Dumb luck on my end.

So what I’m hearing so far is “Just do it”

 

[Chuckanut]

If the managed funds are down due to the current bear market, it would be a great time to tax loss harvest and reinvest into index funds. .

Here's my problem. I have been in some of these funds for so long that even with the market down 20%+ I would have a hefty tax bill if I sold. And other chunk has been in tax defferred accounts so no tax break there.

The one thing I may do soon, is a Roth conversion. From what I can tell there are some modest tax advantages for me, but not a lot of downside, other than a lower net worth on paper. I can live with that if I can avoid taxes on future withdrawals.

 

[RunningBum]

Given the recent market downturn and volatility, I have concerns about the timing of making this transition.

You could spread the exchanges out over few days or weeks. That way you only have a portion of your investments out in case of a big jump up on a day you are in transition.

 

[OldShooter]

... I have been in some of these funds for so long that even with the market down 20%+ I would have a hefty tax bill if I sold.

Well, if they are funds you don't want to be in, a down market is a good time to sell. Don't let the tax tail wag the investment dog. You will probably sell at some point and pay taxes anyway. You can also beneficially use appreciated stock for your charitable giving.

... The one thing I may do soon, is a Roth conversion. From what I can tell there are some modest tax advantages for me, but not a lot of downside, other than a lower net worth on paper. I can live with that if I can avoid taxes on future withdrawals.

Remember a Roth conversion is simply a tax rate arbitrage play. Pay now or pay later, but you'll always pay. If your net tax now (including IRMAA, state tax, ACA effects, etc.) is lower than it will be when you expect to withdraw your funds, you are better off converting. Higher future rates might be due to looming RMDs. If the future tax rate on withdrawals will be lower, you lose by converting. Examples of the latter might be heirs with lower tax rates than yours or charities where the tax rate will be zero. Or just a future where you expect our own tax rate to be lower.

A second-order effect is that a conversion will reduce your RMDS. If that is desirable then you may want to do conversions even if the tax rate at withdrawal time will be the same as your tax rate now. The problem being, of course, to predict future tax rates.

 

[PaunchyPirate]

I have tax loss harvested a significant amount this year. I am using those losses to offset the gains I have from also selling a couple high cost, managed mutual funds that I have held for years but I no longer wanted in my portfolio. I took the funds from the managed funds and immediately added them into holdings of Vanguard’s Total Stock Market Fund. My portfolio is now simpler and has lower costs.

 

[target2019]

Thanks for the quick responses. My taxable account is of little concern as few equities remain there. Harvested all gains there over past few years to fund expenses in years 2-4 of retirement while putting us in the 0% federal tax rate and staying just under the 400% poverty rate for ACA subsidy purposes. That party is over in 2022, but the ACA subsidy cliff is temporarily on hold. Dumb luck on my end.

So what I’m hearing so far is “Just do it”

If it's mutual funds or ETFs, and your platform has the feature, you just exchange Active for Passive and go on with other challenges in life.

 

[OldShooter]

If it's mutual funds or ETFs, and your platform has the feature, you just exchange Active for Passive and go on with other challenges in life.

Huh? I interpret the OP to be asking about moving from actively managed funds to passive index funds. There is no tax-free exchange available for that. Possibly you are thinking of conventional mutual funds with ETF counterparts. Those two are fundamentally the same thing, no change in investment strategy and very little reason to do.

FWIW, the "F" in ETF stands for "fund." They are mutual funds, just of a slightly different type than conventional funds. The industry has promoted them like they are some big deal, IMO mostly because they can be day-traded.

 

[target2019]

Huh? I interpret the OP to be asking about moving from actively managed funds to passive index funds. There is no tax-free exchange available for that. Possibly you are thinking of conventional mutual funds with ETF counterparts. Those two are fundamentally the same thing, no change in investment strategy and very little reason to do.

FWIW, the "F" in ETF stands for "fund." They are mutual funds, just of a slightly different type than conventional funds. The industry has promoted them like they are some big deal, IMO mostly because they can be day-traded.

He has stated his taxable account is of little concern. Most of us don't need a lecture on MF/ETF.

 

[OldShooter]

Sorry. Then I don't understand your post. The OP can always buy and sell in a tax sheltered account, whether it's MFs or ETFs or something else. Schwab does have an option where you can create the necessary two trades, sell and buy MFs, with one order, but that's not an "exchange." Probably others have this too.

 

[scrabbler1]

The ACA premium subsidy cliff was the main driver when I unloaded a large holding in an actively managed stock fund and replaced it with an index fund which included a similar set of stocks.

It was the end of 2019, and I was close to the ACA premium subsidy cliff after going over that cliff in 2017 and 2018. I sold some specific shares at a small loss to try to give myself an added cushion in case the actual CGD ended up being a little higher than its estimate. But the actual distribution ended up being somewhat higher and would put me over the cliff again with no way to avoid it.

But this time, unlike in 2017 and 2018, the cost of going over the cliff was larger than before, and I did not want this to happen again in 2020. So, part of my plan in case this happened was to ditch the entire fund and replace it with an index fund, one which came into existence back in 2016.

I had a large unrealized cap gain in the outgoing fund, so I didn't want to make this large exchange in 2020 and mess up my chance at getting back on the ACA premium subsidy train. I knew I had little time to pull the trigger on this big move because it was already December 30th. If I was going over the cliff in 2019, it didn't matter by how much.

I ended up with a pretty large tax bill due to the large CGP and the gain on the sale of all the shares I was liquidating. It took 2 years of ACA subsidies to recover all the added taxes I paid for the liquidation. So this year I am finally getting back into the black from that sale.