By now, hopefully you know that the top priorities for investing are (a) invest early, (b) invest often, and (c) build an asset allocation that matches your risk tolerance and risk capacity. (I've linked to that article an order of magnitude more than any other, so you better!)
And that's relatively easy to do when all your assets are in a 401k. You just log in, build the portfolio, assign percentages, and click "go", and the 401k administrator handles everything, generally with no transaction fees. But what if you've got a bunch of assets in a taxable account -- assets that have done well, and thus would incur significant capital gains tax if you touched them?
Good question. Let's walk through the analysis of a few scenarios.
Capital Gains v. Expense Ratios
Over and over again, research shows a high correlation between low fund fees ("expense ratios") and investment outperformance. (This applies equally for mutual funds and exchange-traded funds (ETF's); for the rest of this discussion, I'm just going to say "funds".) Therefore, given two funds with no clear, long-term differentiator between the two, a smart investor would pick the one with the lower fees. But what if you're already invested in the high-cost fund with capital gains in a taxable account? Is it still worth it to switch over?
It's a good question, so I created a spreadsheet for it, naturally. I make some assumptions about capital gains tax, projected annualized returns, and the fee difference of the funds in question, and run the numbers to see how long it takes the higher-performance fund to catch up.
Also, I include a key fact that people tend to forget: you're going to have to pay that capital gains tax eventually! (Well, unless you die before you sell the fund, but that's not your plan, is it?) All you're doing by not selling the high-cost fund now is kicking that can down the road. So to have an apples-to-apples comparison, I compare the value of the two funds after they've been liquidated, thus taking capital gains tax into account for both of them. If you switch to the low-cost fund early on, you'll pay more tax up front, but less tax later; while you may delay that tax bill if you hold on to the high-cost fund, you'll pay a lot more when the time comes to liquidate!
As you might imagine, the length of time it takes for the low-cost fund to catch up varies greatly depending on your variables. Higher capital gains and/or a higher tax rate make it take longer; lower overall projected returns and higher return differentials speed up the process. So I figured, rather than creating a bunch of rules of thumb, why not clean up the spreadsheet a bit and make it publicly available? This way, you can put in your data and see what's relevant to you. Here's a link for getting your own copy. By no means am I a spreadsheet wizard, so feel free to drop me a line if you have any suggestions on improvements!
Capital Gains v. Rebalancing
Similarly, you may be wondering how to weigh the need to rebalance your portfolio to match your risk tolerance and capacity against the desire to delay capital gains taxes. There are two scenarios worth considering:
Annual rebalance: let's start with the easy one first. When you do your annual rebalance, you may find it hard to pull the trigger on selling those overperforming assets to buy more of the underperforming ones -- especially when you're looking at paying capital gains! To this I say: suck it up, Buttercup. Like I mentioned earlier, you're almost certainly going to have to pay those capital gains taxes eventually anyway, so you're not actually gaining anything!
More importantly, letting those overperforming assets run for longer than a year means you've now let your asset allocation slide. By rebalancing, you're getting back to the first priority, which is building a portfolio that matches your risk tolerance and risk capacity. Sure, it was nice when tech stocks went gangbusters in the 90's. But did you really want to be 90% in tech stocks in 2000?
Initial rebalance: when you're first moving from an ad hoc portfolio to a more systematic one, you may find yourself looking at some serious capital gains. Maybe you've got employer stock that you want to diversify out of (hello, Amazonians and nVidians!). Maybe you're at 90% stocks and want to get down to 60%, but you've benefited from a historically unprecedented extended bull market. This time, there's not even a relatively simple spreadsheet for you to look at -- you can't make an apples to apples comparison when you're looking at something that doesn't fit your risk tolerance! At this point, you're playing a game of hot potato, where the object is to diversify out before your portfolio takes a serious hit, but the unfortunate reality is that you have no idea when that will be. It could be tomorrow. It could be a decade from now. In this case, you'll have to make an educated guess, considering a few factors.
First: I keep harping on this, but it's only because it's important: you're going to have to pay the capital gains tax eventually anyway. All things being equal, especially if your portfolio's risk is out of whack, why not pay it now and take the chips off the table? Is a capital gains tax deferral really worth the potential of blowing a hole in your financial plan?
However, there are some cases where you may actually pay less in capital gains tax if you spread out the sales. For example, if you're sitting on several hundred thousand dollars of capital gains and/or make several hundred thousand dollars a year in income, you may be looking at a bump up from the 15% to the 20% tax bracket -- and unlike the progressive ordinary income tax, capital gains tax is applied to every dollar of capital gains for that year! So in this case, perhaps -- perhaps -- it might make sense to spread out the transition. Keep a few things in mind, though!
First, assume that any individual stock positions could pull an Enron and vaporize. Sure, that's unlikely, but you need to consider the possibility. If the stock going to zero won't really affect your financial plan, then sure, feel free to spread out the capital gains sales over a few years. (Sell some now, though. Please.) But if a significant percentage of your net worth is tied up in a single stock, don't wait! Sure, you may be sad if the stock keeps going gangbusters and you miss out -- but you'll be even sadder if you have to delay retirement by 10 years because it goes down the tubes overnight.
Also, even if you don't have an individual stock positions, assume that at any point you could lose half your diversified equity portfolio. So if you're 90% stocks in a broadly diversified portfolio, its value could drop by 45% in a matter of months. (By the way, this has always been the rule ever since I got into investing around 2000, and the 2008 financial crisis empirically validated that rule when it saw most portfolios drop by roughly 50% of their equities!) Again, if you're OK with this, then you might consider spreading out the rebalance over several years -- but proceed with caution!
Overcome your pain of paying
Having said all this, I know: it's hard to willingly pay taxes now to avoid a potential badness or achieve a potential goodness later. As much as you and I like to think we're rational human beings only motivated by logic, we all have our own foibles. And our "pain of paying" generally serves us well, right? It encourages us to find good deals, to avoid buying something just to "keep up with the Joneses", to repair things rather than replace them outright.
This time, though, consider that it might be worth it to spend that money. Run the analysis, consider the risk, set aside your procrastinatory tendencies, and then create a plan for biting the bullet. Remember, in the case of capital gains tax, it's generally not an "if", but a "when"!
Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.