A common question from readers is what to do about an account that contains a bunch of high expense ratio mutual funds or individual stocks.

The reason for having such an account varies from person to person. Maybe it was the only funds available to them in their 401(k) portfolios. Perhaps they collected a bunch of individual stocks and actively-managed mutual funds over the years based on tips from magazines or friends. Sometimes they were put into these positions by a financial advisor, and now they want to manage their own investments.

Whatever the reason, they now have a collection of high expense ratio mutual funds or individual stocks that they want to convert into a three-fund portfolio or another basket of index funds.

How might you go about doing that? Unfortunately, in many cases, it’s not as easy as just dumping all your old investments and buying the appropriate index funds. There are tax and other considerations that might merit a more nuanced approach.

An Example

This comment I received from a reader highlights the quandary that many physicians have when trying to unwind an old portfolio.

I am a 50-year-old cardiologist who decided about 3 years ago to ditch my 1% of assets under management FA.  I was able to convert the accounts over to my name without selling the funds as my FA used Schwab as a custodian.  I have a sizable taxable account and live in a state with state capital gains.  My struggle right now is if it is worth converting my current actively managed funds to index funds which would, of course, trigger significant capital gains.  I have tax harvested all I can.  I put some in a Directed charity account.    I am worried that if I incur the tax burden now I lose the compound growth going forward but then face the 1.2% drag on my return due to the high ER.

Retirement accounts — just trade out and buy the index funds

If you have investments you don’t like in your retirement accounts, it really is as easy as just dumping your old investments and switching over to your new index funds.

Since the accounts are tax-protected, no capital gains taxes are incurred when you sell shares. Therefore, in most cases, I would just recommend immediately switching out from the high-cost mutual funds to the set of index funds you desire.

These trades can be done all at once if you want. Because of psychological reasons, however, many investors may prefer to do it more slowly.

Taxable Accounts Require A More Nuanced Approach

Importance of choosing your taxable account wisely

First, this quandary faced by many physicians highlights the importance of choosing your taxable account allocation wisely. New physicians would do well to decide early in their careers how they want their taxable accounts to be invested, as changes become more difficult once you’ve accumulated a lot of capital gains.

Sell off any negative losses to offset capital gains

If you have any losing stocks or mutual funds, you could sell those shares and generate losses that would then be used to offset profits from other investments. However, you probably won’t have many losses in your account given the long bull market we have had.

But hopefully you will continue to put money into the market with each paycheck, and when the inevitable correction/bear market occurs, you can sell both your winners and losers. Remember to follow wash sale guidelines or else you might have to pay taxes on the capital gains but not get credit for the losses.

Consider moving money to a donor-advised fund

Some physicians have a desire to contribute to charitable causes using their investments. The use of donor-advised funds allows you to get the tax deduction from a large charitable contribution before actually donating the shares to charity. When you decide to eventually donate your shares to charity, you do not have to pay capital gains taxes, amplifying the impact of your donation.

What if you still have capital gains in your taxable account?

Even after you exhaust the above strategies, you might still have some unrealized capital gains in your taxable account. In this case, there is no clear-cut answer on whether to liquidate and take the capital gains or stick with your current investments and possibly be paying more in investment fees.

There are three numbers to consider in this situation: the amount of taxable gains in your account, the number of years left until retirement (or liquidate your taxable portfolio), and the fees/costs associated with keeping your current investments.

1. Amount of Taxable Capital Gains — the more capital gains you have, the more likely you should keep your investments
2. Fees associated with keeping your current investments — the higher the fees you have, the more likely you should switch your investments
3. Years Until Retirement

Remember that what you lose is not the actual amount of the taxes — you will have to pay them eventually and the rate won’t change unless you are able to significantly lower your tax bracket in retirement and employ tax gain harvesting techniques.

What you lose is the opportunity cost of your capital gains going to the government instead of continuing to grow for you (i.e. the interest on interest).

Example 1: An individual stock with large capital gains

If you are in an individual stock that you bought many years ago that has doubled or tripled, you probably should just hold it until retirement. There are no fees/costs associated with holding an individual stock; the only downside of holding an individual stock is its lack of diversification. Unless a single stock represents a large percentage of your portfolio, its probably holding onto until retirement.

Example 2: A high-fee mutual fund with small capital gains

On the other hand, if you have a high expense ratio mutual fund, every year you continue to hold the mutual fund will hamper your returns going forward. In this scenario, it’s probably worth it to switch to index funds.

Example 3: A high-fee mutual fund with large capital gains

Here, there is no clear-cut answer. You will have to run the numbers in both scenarios (keeping old investments versus switching to new investments) and see in which scenario you’ll end up with more money. The math is complicated, but here’s a back-of-the-envelope way to compare your two options:

1. Option 1 (Keep old investments): Multiply your current investment by your expected return (minus fees) until retirement. Then subtract the capital gains tax.
2. Option 2 (Switch to new investments): Subtract the capital gains from your current investment. Then multiply this amount by your expected return (minus fees) until retirement. Then subtract the capital gains tax again.

Simplicity is often best — can forget past mistakes and have a fresh start

For many people, simplicity might trump the math. Even if it might be mathematically sound to hold on to an individual stock or mutual fund that has significant capital gains, the satisfaction from having a simple portfolio can outweigh any tax costs from liquidating the portfolio.

Going back to the reader’s original question

Let’s go back to the reader’s question. He has 15 years to go in his career before he is retired, and has significant capital gains, but his mutual fund has a 1.2% expense ratio. Unfortunately, one of the most important questions is how much unrealized capital gains there are in his investment. Remember that the 1.2% in expenses is eroding his entire portfolio. I would lean towards liquidating the account and paying the long-term capital gains, unless his mutual fund has doubled or tripled his money.

What do you think? What would you do in our reader’s situation? Are there any other considerations when liquidating a taxable account portfolio?