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In the last 5-7 years, I've gradually invested money in several mutual funds via my bank (USAA). These funds now make up about a third of my portfolio. Initially I had invested in these funds because it was very easy to do: I already had an account at the bank, and the online system made it simple to create mutual fund accounts and set up auto-investing.

However, more recently I've started to take more notice of how high the expense ratios are on these funds. I'm considering opening up some accounts at Vanguard and moving my money there, into index funds that cover the same categories but with substantially lower expenses.

My existing funds (at least, the ones I'm planning on moving) are in taxable accounts. As I understand it, as long as I remain in the 15% tax bracket or lower (which is where I currently am), my long-term capital gains tax rate is zero, so I could sell these funds and use the money to buy into lower-expense Vanguard funds with effectively zero cost (as long as I don't sell enough to push me into a higher bracket in any single year). So that's what I'm contemplating: gradually selling off the USAA funds --- as much as I can each year without incurring taxes --- and instead buying cheaper Vanguard funds.

So my question is: is this a good plan? Am I understanding the tax situation correctly, such that I can really do this at no cost? Is it worth it to worry about the taxes, or should I just move all the money at once (even though it would definitely push me into a higher bracket and incur a tax)? Also, supposing I try to avoid the tax in the way I outlined, is there any way to do it other than keeping careful track of my expenses and, at the very end of the year, selling just as much as I think I can safely sell? (It's obviously not the end of the world if I accidentally sell $100 too much and have to pay a small tax, but, also obviously, I'd rather avoid it, and I'm curious if there's any way to do so that doesn't rely on my own accuracy in knowing exactly what my income was.)

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2 Answers

up vote 4 down vote accepted

Expenses matter. At the back end, retirement, the most often quoted withdrawal rate is 4%. How would it feel to be paying 1/4 of each years' income to fees, separate from the taxes due, separate from whether the market is up or down? Kudos to you for learning this lesson so early.

Your plan is great, and while I often say 'don't let the tax tail wag the investing dog' being mindful of the tax hit in any planned transaction is worthwhile.

Selling and moving enough funds to stay at 0% is great, a no-brainer, as they say. Selling more depends on the exact numbers involved. Do a fake return, and see how an extra $1000/$2000 etc, worth of fund sale impacts the taxes. It will depend on how much gain there is for each $XXX of fund. Say you are up 25%, So $1000 has $200 of gain. 15% of $200 is $30. A 1%/yr fee cost you $10/yr, so it's worth waiting till January to sell the next shares of the fund.

Keep in mind, the 'test' return will still have the 2013 rates and brackets, I suggest this only as an estimating tool.

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Thanks. I only wish I'd thought of this a couple months ago, as now I will have to wait till the end of the year to be sure of how much I can sell (although I will probably sell some before that based on my estimates). –  BrenBarn Feb 23 at 5:11
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In addition to all the good information that JoeTaxpayer has provided, be aware of this.

When you sell mutual fund shares, you can, if you choose to do so, tell the mutual fund company which shares you want to sell (e.g. all shares purchased on xx/yy/2010 plus 10 shares out of 23.147 shares purchased on ss/tt/2011 plus...) and pay taxes on the gains/losses on those specific shares. If you do not specify which shares you want sold, the mutual fund company will tell you the gains/losses based on the average cost basis and you can use this information if you like. Note that some of your gains/losses will be short-term gains or losses if you use the average cost basis. Or, you can use the FIFO method (usually resulting in the largest gain) in which the shares are sold in the order in which they were purchased. This usually results in no short-term gains/losses.

Just so that you know, most mutual fund companies will link your checking account in your bank to your account with them (a one-time paperwork deal is necessary in which your bank manager's signature is required on the authorization to be sent to the fund company). After that, the connection is nearly as seamless as with your current system. Tell the fund company you want to invest money in a certain mutual fund and to take the money from your linked checking account, and they will take care of it. Sell some shares and they will deposit the money into your linked bank account, and so on. The mutual fund company will not accept instructions from you (or someone purporting to be you) to sell shares and to send the money to Joe Blow (or to Joe Taxpayer for that matter): the proceeds of redemptions go to your checking account or are used to buy shares in other mutual funds offered by the company (called an exchange and not a redemption).

Oh, and most fund companies offer automatic investments (as well as automatic redemptions) at fixed time intervals, just as with your bank.

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Can you clarify why you suggest OP sell specific mutual fund shares? I assume you're advising to sell shares with the greatest long-term gain first so it is taxed at 0%? –  Craig W Feb 22 at 17:01
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@CraigW The OP can choose to sell specific fund shares if that helps in tax avoidance. Some shares might have losses while others have gains, and so more shares could be sold while still keeping below the threshold where the capital gains tax rate increases above 0. –  Dilip Sarwate Feb 22 at 18:24
    
@CraigW - Say OP has $10K of shares with $5K gain, and $10K with $1K gain. The lower the gain, the more shares he can sell at zero tax. If his goal is to move as much as he can, this strategy is ideal. –  JoeTaxpayer Feb 23 at 13:32
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