[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!