Good luck!
Your friend Jeff owns a mutual fund worth $100,000 in his taxable account. Jeff has been considering selling the mutual fund and replacing it with a similar investment with lower fees (and, therefore better projected net of fees returns). However, Jeff is leaning toward not selling his mutual fund because his cost basis on the mutual fund is $75,000, so selling it would create a taxable gain of $25,000.
Assume that his mutual fund will return 5% per year for each of the next 10 years (after fees). Assume that the similar investment will return 6% per year each year for each of the next 10 years (after fees).
In which of the scenarios below will Jeff accumulate the most money at the end of 10 years?
Scenario A: Jeff keeps his mutual fund for the next 10 years.
Scenario B: Jeff sells his mutual fund, and immediately reinvests the net of tax proceeds into the other investment.
Assume that Jeff has a tax rate of 20% on long-term gains and that all of the gain of $25,000 would be taxed as a long-term gain. For the purpose of this example ignore the effects of periodic distributions from the mutual fund.
Scenario A: $100,000 x 1.05 10 = $162,889.46
Value of the mutual fund after 10 Years = $162,889.46
Scenario B: $100,000 - ($25,000 x 0.20%) = $95,000 is Jeff's net of tax proceeds on the sale of the mutual fund.
$95,000 x 1.06 10 = $170,130.53
Value of the other investment after 10 years = $170,130.53
In this scenario, Jeff will be better off after 10 years by selling his mutual fund and taking the one-time tax hit than he would be keeping his money in the higher fee mutual fund.
Irrational tax aversion can sometimes lead investors to make sub-optimal investment decisions. Rather than considering the benefits of switching to a more optimal investment and weighing those benefits versus the costs of a one-time tax hit, some investors let tax considerations alone drive their decision making.
Ideally, tax considerations should be one part of the cost/benefit analysis of decision making rather than the only part of decision making in taxable accounts.
Check out another quiz from Doug's Quiz Corner!
To learn more about some of the factors that may affect your return and to discuss your strategy give us a call at 1-800-541-7774 or contact us here to get in touch with one of our Wealth Managers.
This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.