[Editor's Note: This is a guest post from the Physician On FIRE, one of the more prolific of the physician financial bloggers who have started up in the last year or two. He is not only a talented writer, but an exceptional marketer of his writing so I'm proud to feature him here. In this piece he talks about how he got rid of some investments in his taxable account that he realized were not so wise. We have no financial relationship.]
If you've made unwise choices in a tax advantaged account, there's an easy fix. Exchange the investments you no longer want for something more desirable. In any Roth account, 401(k), or similar retirement account, there are no tax consequences to your buying and selling [although there may be commissions or other expenses-ed.]
If, like me, you've made some less than ideal investments outside your retirement accounts, your exit strategy is not so simple. You'll have to consider a number of factors, including the tax implications of selling, the cost and opportunity cost of keeping the investment, and alternative methods to jettison the investment from your portfolio.
When I was a relatively new attending, I had a cursory understanding of personal finance. I knew enough to avoid most major mistakes, but I had not taken the time to understand the finer points. It's tough to find time when you've got a growing family, huge new house to fill, and a couple of fantasy football teams to manage. If only I had spent half the time on my finances as I did on my fake football teams, I wouldn't have gotten into the funds that I did.
I could have done worse, and I imagine many of you have. I had read Andrew Tobias' The Only Investment Guide You'll Ever Need as a medical student. Now that I found myself with money left over at the end of each month as an attending with a few years of experience, I was compelled to put that money somewhere.
At the end of The Guide, a few fund families are listed. Vanguard was listed first, and described accurately as a low-cost provider. Well, that sounded alright, but T. Rowe Price, a more regal sounding name, was touted as great for beginners, with a mountain of resources, having great customer service, all while offering “among the lowest expense ratios in the industry.” That sounds good; I'll have that.
I had previously started my SEP-IRA with them, which made me even more comfortable starting my taxable brokerage account at T. Rowe Price.
Building Up The Taxable Account
I wanted some diversity, so I chose what looked like a good potpourri of domestic and international funds. I even put a little money into a tax-free bond fund. Here are the funds I chose.
Did this give me diversity? Yes. I had growth funds, international funds, and a bond fund. The two Spectrum funds were actually funds of funds, holding a handful of T. Rowe Price funds in each. Did I have Total Stock Market diversification? No, but I didn't know much about index funds at the time.
Were my expenses among the lowest in the industry? No, not even close. I could have been more diversified with two Vanguard or Fidelity funds, while having 1/10th the expenses. A weighted average of my current portfolio's funds' expense ratios is 0.08, one tenth that of the above portfolio.
What was my rationale? If I knew then what I know now, I would have made different choices. Expenses under 1% seemed reasonable. I didn't realize that investment fees can cost you millions. I did look at some graphs and charts and Morningstar star ratings, for what it's worth, which in hindsight, isn't much. When I started this account, there were some good online resources that I hadn't yet found, but The White Coat Investor site did not yet exist. [Sorry about that, I was busy making my own mistakes. As bad as Personal Strategy Growth might look, it pales in comparison to whole life insurance-ed.]
For three years from 2010 to 2013, I funneled as much money into these funds as I could. When I worked locums, the proceeds went into the taxable account. By the fall of 2013, I had built the account up to a value of $369,000. Awesome! I had also discovered Bogleheads, rediscovered Vanguard, and realized I was losing money to fees while invested in tax-inefficient funds. Not Awesome!
Unwinding What I Had Done
My first instinct was to sell it all and start anew, but the capital gains alone would have pushed me well into the highest tax bracket, the one where capital gains are taxed at 20% instead of 15%. I didn't know a lot, but I knew I didn't want that.
We were planning a move at the time I realized I had chosen the wrong funds. We would need a new house, and I decided to buy the house with cash. I had been building up a cash reserve, but not enough of a reserve to buy a home outright, even in the low cost of living area where we were headed. That fall, I sold about half of the funds after we found a suitable home for our family.
I consulted with my accountant in December. Between a busy locums schedule that added a six-figure sum to my salary and a sizable capital gain from selling off half the funds in the taxable portfolio, I was still destined for the top federal income tax bracket and the 20% capital gains tax bracket unless I did something to lower my tax burden.
So I did something.
I had researched donor advised funds, and decided it was time to start one of our own. I donated about $60,000 from the funds with the most appreciation, more than enough to bring our taxable income out of the top bracket. In any year, the IRS allows you to donate equities adding up to as much as 30% of your taxable income. If you're giving cash, it's 50%. Every dollar donated is a dollar that's not taxed.
In 2014, this taxable account was worth about a third what it was at its peak. I was done contributing to it, but it continued to cause tax headaches. In 2013, aside from the capital gains I incurred by selling, the funds spun off over $6,000 in dividends (mostly ordinary, non-qualified) and over $6,000 in capital gains distributions. In 2014, I still saw over $4,000 in dividends and nearly $7,000 in capital gains distributions despite having less than $120,000 in the account.
I made another good-sized contribution to the donor advised fund late in 2014, and again in 2015. Before the first quarterly dividend date arrived in 2015, I decided to cut my losses, take my gains, and move the last of my T. Rowe Price account into Vanguard index funds.
Lessons from my folly
Is T. Rowe Price a bad company? No, not at all. But if you plan to be a do-it-yourself investor, you should do all you can to minimize your fees. I like Vanguard, but they're not the only company selling index funds with expense ratios below 0.1%.
Tax efficiency matters. I now have a seven-figure taxable portfolio, and the tax burden imposed is about the same as it was when I was invested in less tax-efficient funds with a portfolio one third as large.
Have a well researched plan before you start investing in a taxable account. Changes are easy to make in your 401(k) and other tax advantaged accounts. In a taxable account, if you've seen any gains, you will be taxed when you decide to sell.
It's not too late to make changes. While you will be on the hook for some capital gains taxes, it probably makes the most sense to move on and swallow your pride when you realize you've got investments that don't make sense in your portfolio. If I had held onto those funds indefinitely, the ongoing expenses and tax drag would easily exceed the cost of exiting out of them when I did.
Giving is good. You can donate equities directly to charities, or indirectly via a donor advised fund, as I have chosen to do. While you won't come out ahead financially by giving a dollar to save forty cents, if you plan on being charitable, starting a philanthropic fund is a great way to relieve yourself of the burden of a stock, fund, or even property that you would rather not have.
What do you think? How do you get rid of appreciated assets you don't want in your taxable account? Have you used a donor advised fund? What other strategies do you use to lower your investing related taxes? Comment below!
Great post. So thankful I found WCI in my last year of residency so that I could avoid this type of headache. My taxable account currently consists of a Total Stock Market Index Fund, a Total International Stock Index fund, and a Municipal bond fund. My taxable account has a much larger balance than my savings account, and the taxes from my taxable account (treated primarily as qualified dividends) are nearly the same as the taxes from my savings account (treated as ordinary income). Thanks again for all the help over the years.
Nicely done, LFMD. Tax drag can be a real… drag, but I’ve lowered mine drastically since making these moves.
WCI wasn’t writing when I started these investments, but there are more and more resources every day — I see you’re joining us with a site of your own. I look forward to reading more of your story!
Best,
-PoF
Thanks for the article. I’m so glad you guys are writing. These are the kinds of things that doctors need to know, especially when starting out. Earlier and smaller errors are easier and less costly to correct than later on.
What do you think of vanguard tax managed funds? They are mostly passive index funds but have a higher fee than just a S&P 500 fund or ETF.
Happy to be featured here, and you’re right, nipping this “problem” in the bud before the funds had too many years to grow was the right move.
Tax managed funds? Bogleheads (another favorite site of mine) covers them well here https://www.bogleheads.org/wiki/Tax-managed_fund_comparison I don’t own them, and I think the funds I do own (Total Stock Market, S&P500, and Total International) do a pretty good job with tax efficiency already.
The most tax efficient equity I own in taxable is also the only individual stock I own – Berkshire Hathaway.
Best,
-PoF
I’m not a huge fan, but they’re not as bad as they used to be. There used to be a requirement to hold them for years (5 I think) or pay a penalty for selling, which made it hard to tax-loss harvest them. I think that went away a few years ago.
As the boglehead data suggest, the biggest benefit is in the higher brackets; I use them, for now at least.
What are the expenses of the DAF? Seems like you may have traded one type of expense for another.
JZ nailed it below.
Interestingly, the 0.6% fees incurred in the DAF are nearly identical to the ~0.6% tax drag on index funds I hold in a taxable account. Those roughly 2% dividends are subject to 15% LTCG / QD + 3.8% ACA tax, + 9.85% state income tax. So it’s pretty much a wash.
Much more impactful is the fact that the money in the DAF isn’t mine anymore, and I’m OK with that!
The DAF fees are 0.60% + ER at both Vanguard and Schwab, or a minimum of $100 annually. I’ve used a Schwab DAF for one year and the service and communication are fabulous. The $100 fee is easily worth it. I plan to superstock our Schwab DAF in 2017 with appreciated ETFs before we launch in retirement , yet exploiting the charitable deduction while our current income is high.
I was wrangling to understand the Schwab DAF fees + ER fees until a service rep explained that they adjust the fee every July to total at least $100 annually. At that rate I won’t anguish.
Vanguard’s DAF requires a $25K initial deposit and donation minimum’s of $500 each, which I will eventually offload some appreciated stock mutual funds dating from the mid 1990s. Until then, I will use Schwab’s DAF which allows some smaller donations of only $100.
I also transfer appreciated securities to my 3 kids in their twenties. Their tax brackets are low, incurring lower LTCG.
POF, you were clever to use the DAF to off load your appreciated securities. You are young, so may be fully set for philanthropy at an early age.
Thank you, JZ, and you’ve done a great job of detailing the fees and minimums in those DAFs. Mine are with Vanguard and Fidelity.
I’ve made it a goal to have a DAF balance equal to 10% of my retirement assets, and we’re pretty close after making a recent contribution. One more large gift next year should get us there.
Cheers!
-PoF
I had some individual stocks early on before moving to index funds. Most however were still stalwart s&p 500. As such I didnt have as much of a drag. I’ve slowly unloaded a little a year into index funds. The biggest gainer I actually unloaded during the 2008 crash. They were still up more then my purchase price but much reduced from the cap gains I would have seen in 2007. Immediate reinvestment in index funds of large caps really meant I sold like and reinvested in like as far as I’m concerned.
For those who are less charitably inclined, and wish to diversify away from a single security (or get rid of bad investments in a taxable account) without suffering the full capital gains tax consequences in one year, a “charitable remainder unitrust or CRUT” would be worth exploring.
Good point. CRUTs are discussed more here: https://www.whitecoatinvestor.com/charitable-trusts-crats-cruts-clats-cluts/
It’s good to look over your portfolio every now and then checking for sub-optimal funds. I thought I had eliminated most of them, but recently found $26,000 in our IRAs that was invested in high fee mutual funds. The mutual funds were not even performing very well. Luckily they were in our IRAs and I was able to swap them out for some total market index funds without tax implications. That one simple swap saved us $250 in yearly fees, not to mention we got a better performing fund. And $250 goes a long way for an early retiree, it covers my gym membership for the year 😉
That’s a pretty good deal for a gym.
Nice post PoF!
I have experienced these problems of tax issues in taxable accounts 2 years into investing. 25% of my taxable portfolio is in Vanguard funds (large cap, mid cap, small cap and bond fund – tax exempt). They all are passive, but they do bring in some capital gains during the end of the year and they also bring in the dividends. One way to be more tax efficient is to invest in corresponding Vanguard ETFs. However, with the DOW near its all time high – I do not know how and when to do it. Any thoughts?
I also do like idea of robo-advising which can help you with tax efficiency and rebalancing. Currently I do like to set up an auto-investing feature at Vanguard into my funds, but with ETFs it might nt be that easy as fractional shares can’t be purchased unless you are these robo-advising companies. What are your thoughts on these firms like Wealthfront and Betterment?
75% of my taxable portfolio is in individual (mostly) dividend paying stocks – they do bring in a fat dividend check – but I like DGI as I have age by my side. Any thoughts on how to get more tax efficient there? I do like the stocks that I own and the size of this investment is Already larger than my retirement account. I know I can control the capital gains in this section.
Your input would be appreciated !
Thanks
MT
More details on Betterment and Roboadvisors can be found here:
https://www.whitecoatinvestor.com/what-you-need-to-know-about-roboadvisors/
https://www.whitecoatinvestor.com/simple-investing-solutions-including-betterment/
https://www.whitecoatinvestor.com/betterment-tax-loss-harvesting/
Your options for dealing with low basis shares are:
1) Hold until death (heirs get step-up in basis) and adjust your portfolio as needed
2) Gift to family members in a lower bracket and have them sell them
3) Donate to charity (either directly or through a DAF or a CRUT)
4) Offset the capital gains with capital losses
5) Just bite the bullet and sell them and pay the taxes
I still own some “legacy” actively managed equity funds–T Rowe Price and Vanguard–maybe 2% of my net worth (and falling). I have not added to them in years and no longer reinvest dividends/cap gains. I peel off some every year to my DAF. This year, the Vanguard PrimeCap Core Fund hit me with a significant distribution, which is making me reconsider continuing to hold it.
You bring up a good point. The FIRST thing you should do when you realize you are holding investments you’d rather not own is to turn off automatic reinvestment in those funds.
That way, at least you won’t buy any more than you already have. If you have definite plans to sell, exchange, or donate them in the immediate term (before the next dividend date), I suppose it doesn’t matter much.
Best,
-PoF
Yes I have a legacy problem with a couple of American Fund actively managed funds. They are in a taxable account with about 0.6 ER. Low basis. I have not reinvested for years. When I get these year end pesky distributions I use the money to rebalance and have funded a short term money market and bond fund to be used for expenses after I completely retire. I certainly would not buy these now but you have to deal with what you have and make the most of it.
put half of taxable investments or more in individual munis
Gifting low basis shares to family members is an excellent option, too often overlooked. I’m earmarking a few of my high cost “legacy” funds for future cars and weddings.
A long term strategy to avoid hugely appreciated taxable assets is to add a new equivalent replacement ETF every decade.
Eg #1: for midcaps, I used a VOE/VOT combo for the past decade. These are now mature, so I’ve started a VO.
Eg #2: I used Vanguard VTCLX since the early 1990s. It is mature; I leave it dormant, and have started a VONE for rebalancing and poss. cap losses.
Thanks for sharing PoF. Always interested in hearing about others’ investing experiences. I recently got out of all non-tax advantaged retirement accounts. Luckily for me, the capital gains rate should be fairly low giving my meager income as a resident. But when I do have some money left over at the end of the month, I will have this to refer back to.
Cheers!
It’s great to have the knowledge you do as a resident. You shouldn’t have to worry about making the wrong choices when you have money to invest in a taxable account. I hadn’t found the right resources when I started picking somewhat random, actively managed funds. Won’t happen again.
Cheers to you!
-PoF
Making sure that your portfolio is diverse is quite important. It allows you to make up for some bad performance from other stocks. Hopefully a very diverse portfolio will not sure a huge turn down in revenue anytime soon but making sure there are other sources of income are important. Thanks for your post
Thank you for this excellent post. I have been thinking about similar issues in my taxable brokerage account.
Fortunately most of my investments are in Vanguard passive index funds and ETFs. I do have small amounts in Vanguard High Dividend Yield ETF (VYM) and Vanguard Consumer Staples ETF (VDC).
Should I sell these assets and invest in Total stock market fund for more tax efficiency?
Thanks for your advice.
Why did you invest in those investments in the first place? Hard to know whether you should change without knowing why your asset allocation is what it is.
You can say it was a combination of lack of knowledge and little spontaneity. I read about these ETFs in an article in Kiplinger’s and found them interesting. They have been doing well performance wise but I am concerned about the possible tax burden. Still have to receive my tax forms from Vanguard.
I’m just starting to invest in taxable accounts. I had read that ETFs are inherently tax efficient, though I’m not sure why.
Based on the above, I thought funneling all my extra money into VTI would be a good idea to start out. This takes care of a lot of diversification problems.
Other attractive ideas to me were high dividend stocks such as REITs or large caps paying dividends >= 4%, but I wasn’t sure what the tax implications would be, as well as having more trouble diversifying when picking individual stocks/sectors. So all I could pull the trigger on was VTI thus far.
My coworker says he wishes he paid a million dollars in taxes a year, who wouldn’t! Basically if you’re making money on dividends who cares. But I don’t want to be inefficient or make small mistakes which hurt in a big way later on.
I think VTI (Vanguard Total Stock Market ETF) is a great option for a taxable account. If you wish to hold REITs or a high dividend stock (i.e. Large Value) fund then that would be better in a taxable account.
Thanks for the reply!
Trying to understand this, did you mean tax advantaged accounts are better for dividend producing stocks? If so I think I’m starting to get it.
Thanks!
Tax-advantaged accounts are better for everything. But if you have to put something in taxable, I’d put a total market index fund there before a high dividend fund because they have similar expected returns but the index fund is more tax-efficient.