Ask the Spud: Should I Switch All at Once?

In Episode 8 of the Canadian Couch Potato podcast, I answered the following question from a listener named Remy:

I want to move away from my stocks and mutual funds in order to build a Couch Potato portfolio with ETFs. What is the best way to do this? Should I sell everything at once and pay all of the taxes this year, or should I sell my assets over a longer period, like two to three years?

Many investors in Remy’s situation have made that all important first-step: committing to an indexed strategy. But now they’re unsure about how to liquidate their existing portfolio and build the new one. Should you clean house and do it all at once, or take a more gradual approach?

This is an easy decision if all of your investments are in RRSPs and TFSAs. Since there are no tax consequences to selling your existing holdings, you should just liquidate all the holdings right away. But Remy is investing in a non-registered account, and if he’s held his stocks and mutual funds for several years, he’s probably sitting on large unrealized capital gains, so selling these securities would result in a significant tax bill. For example, if his stocks and funds have increased in value by $50,000 and Remy is in a 40% tax bracket, selling them all at once would result in a tax bill of about $10,000. (Only half the capital gain is taxed at your marginal rate.)

So, does it makes sense to realize these gains all at one, and report all of those gains this year? Or should you try to spread out that tax bill over a couple of years instead? The answer will depend on the individual circumstances, but here’s how I suggest approaching the problem.

Consider risk above all else. Let’s say you own a U.S. equity mutual fund that holds several dozen blue-chip stocks and has a fee of 1.75%, and you’re looking to replace that fund with a much cheaper ETF. Your mutual fund is not a ticking time bomb that could blow up your portfolio: it’s just too expensive. So if there’s a large unrealized gain, it might make sense to sell the fund gradually over two or three calendar years to spread out the tax bill. The benefit of the tax deferral might outweigh the difference in fees between the mutual fund and the ETF, and you’re not taking on any additional risk with the more expensive fund.

But now consider a situation where you own three or four small-cap tech stocks with the goal of replacing these with a total-market ETF. Now I would recommend selling the stocks immediately, because holding a small number of individual companies puts you at risk of very large losses and completely undermines your goal of building a more diversified portfolio. So consider yourself lucky to have picked a few stocks that did well, but now it’s time to dump them, pay the taxes, and move on.

Will your tax rate change next year? Tax deferral can be valuable, but it’s only worth so much if you’ll be in the same tax bracket for the foreseeable future. If that’s the case, selling half your holdings this year and half next year would still result in the same overall tax liability (assuming the value of the holdings don’t change), and there isn’t a lot of value in deferring a few thousand dollars in taxes for 12 months.

But now consider some different scenarios. Maybe you plan to take a sabbatical or a parental leave next year, which would put you in a lower bracket. That would be an argument for deferring the whole gain until next year, since it would be taxed much more favourably at that time. On the other hand, if you’re in line for a promotion and expect to be in a higher tax bracket next year, it would make more sense to realize the entire gain now, which would allow you to report it in a year when you’ll pay less tax.

What time of year is it? If it’s January or February and you sell only half your holdings to defer some of the gains, you’ll need to wait until next January to sell the remainder. A lot can happen in those intervening 11 or 12 months, and that’s an argument for selling everything all at once.

However, if you’re overhauling your portfolio and it’s November or December, it probably does make sense to realize half the gains now and half in the new year, because now you’re waiting only a few weeks to get that tax deferral.

In fact, if you have very large capital gains and it’s late in the year, you might have an opportunity to spread them over three calendar years. You could sell a third of the holdings in December, another third a few weeks later in the new year, and the rest the following January. Now you’ve spread the gains over three tax years while making all of the transactions in less than 14 months.

Just do it

One final note: don’t forget that if you do realize significant capital gains in one tax year, you may be able to recover them in the future by tax-loss harvesting.

Let’s say you realize $10,000 in gains when you sell your current holdings. Then next year there’s a sharp downturn in the markets, and now you find your new ETF portfolio is showing an unrealized loss of $5,000. You could sell the ETFs that have fallen in value and immediately replace them with similar (but not identical) ETFs. That would realize a capital loss of $5,000, which you would report on your next tax return. You could then fill out Form T1A (Part 3) to have the losses carried back to offset some of the gains you previously reported. Capital losses can be carried back for up to three years.

As you can see, there are several factors to consider when liquidating a taxable portfolio, but overall I recommend making the transition as soon as you can. Deferring taxes can be useful, but don’t ignore the behavioural pitfalls of hanging on to your holdings. Believe me, you will be tempted to resort to your old ways if one of your stocks has another good year: you’ll question your decision to make the switch (“maybe I really am a great stock picker!”) and the next thing you know, you’ve lost your way. You’ll get off to a much better start if you can leave that baggage behind.

 

8 Responses to Ask the Spud: Should I Switch All at Once?

  1. Greg May 30, 2017 at 11:55 am #

    I’m going through this process right now. Unless there are significant tax consequences from selling everything, I’d recommend to do it, and do it as soon as possible.

    Based on the performance of my mutual funds, they have underperformed broad-based index ETFs by more–in some cases much more–than the difference in MERs. This presents a compelling case to liquidate Canadian high-fee, underperforming mutual funds quickly.

  2. Darren May 30, 2017 at 12:13 pm #

    My 84-year-old father recently asked me to have a look at his finances. He’s had the same financial advisor for many years. As I expected, his investments consist of overpriced, actively managed mutual funds. At least it’s a relatively small number of funds with nothing exotic.
    I was, however, shocked to learn that his portfolio is 100% equity – not a fixed income security in site!
    I discussed it with my father and he’s asked me to help him fix it. Some of his investments are in RRIF and TFSA accounts, but he’s also sitting on some large capital gains in a non-registered account. My plan is to sell enough now to get him to an appropriate asset allocation and then sell the rest over a couple of years to eliminate all the overpriced funds.
    It occurred to me that in my father’s case, there is an additional benefit to realizing the capital gains over the next few years. If we do nothing and wait until his estate is being settled, then all the capital gains will be realized in the same year and the overall taxes payable will be higher. The irony here is that when I talked to the financial advisor, his only justification for the 100% equity allocation was the fact that he didn’t want to trigger capital gains.
    It’s also ironic that without ever appreciating the risk he was taking on, Dad has been well served by his crazy aggressive portfolio. He has more money than I realized and I’ve told him he should go spend some of it. He’s booked on an Alaskan cruise this summer.

  3. Canadian Couch Potato May 30, 2017 at 4:18 pm #

    @Darren: Thanks for the comment. You’ve raised a couple of interesting issues. The advisor’s decision not to realize gains here, in my opinion, was probably a poor one, even though it worked out well.

    The reluctance to realize capital gains always needs to be weighed against the risk of holding stocks that could fall dramatically in value. Your father has neither the time horizon nor the need to take on so much risk. And as you point out, anyone who does not have a spouse should consider realizing gains late in life to avoid a potentially huge deemed disposition on the final tax return. Taken together it would seem wise to take some gains and reduce the risk in this portfolio.

    The Alaskan cruise, however, was excellent advice!

  4. Jungle May 31, 2017 at 12:27 am #

    I did this Jan 2016. Sold all my cad dividend stocks I purchased in 2010 and 2011. At the time of sale, TSX was down, so paid less capital gains. But still had to pay tax.

    Moved everything to max out mine and the wife’s TFSA and RSP. Rebalanced into HXT.

    Did this because:

    Had substantial contribution room in RSP, fair amount in TFSA.

    Dividends (and gross up on tax return )were causing significant clawback to CTB. Adding more than 15% to my income. Since this goes for 18 years and is risk free money, I decided to keep dividends out of non-reg and index to reduce risk of bad stock picks in the future.

    RSP contribution netted a large tax refund, and helped offset the capital gains tax. Then it lowered net income, which will give me more CTB this year. I calculated by doing this, I got 5% more return on my contribution by way of more CTB post June 2017 when they reset calculation. Tax and risk free.

    Now my portfolio is this:

    RSP: VTI, VEA, XIU, XBB
    TFSA, XUS, XEF, XIU, XBB

    I chose Ishares because of liquidity and AUM. US funds are from legacy USD in RSP. I don’t mind paying a little extra mer, especially when you get more liquidity and don’t have to pay huge spreads on bid and ask. Also if shit hits the fan I want to sell bonds and rebalance. So liquidity is important with a strong ETF provider.

    All money sheltered now, and I have ZEN with my portfolio!!

    I think CCP advice of “just do it” might be the best, because if you suffer a bad stock pick (HCG?) this will wipe out any gain you had by waiting for a better time. So he is right, stock picking risk is there.

  5. Paul G May 31, 2017 at 1:05 pm #

    Another variable would be RRSP contribution room. Someone with contribution room could more easily sell unregistered investments and move the resulting funds over to an RRSP and cancel out the capital gains, at least partly.

    (One could wonder why the investments weren’t already in an RRSP, but the investments could be from years ago when RRSP room wasn’t available for whatever reason.)

  6. John Anderson May 31, 2017 at 1:09 pm #

    Triggering significant cap gains may also put you in line for big/bigger quarterly tax payments next year. It’s not a big deal as long as you plan to have the cash available, or go through the paperwork to calculate a lower payment based on expected income for the next year.

  7. Sebastien May 31, 2017 at 1:25 pm #

    @CCP: Good article, but you forgot to mention the deffered sale charges (DSC) that could apply to the mutual funds when selling the units.

    On a more advanced subject, investors should check their effective marginal tax rate (EMTR) prior to their decision to sell their units in a taxable account. They could pay much more than their tax rate by selling part or all of their taxable investments. Sometimes, it could save taxes to sell more even if that mean the marginal tax rate (MTR) will be higher as the EMTR will be lower this way.

  8. Andrew June 16, 2017 at 9:27 pm #

    I am in a somewhat related situation with my RRSP account. I know there are no tax implications, i just can’t pull the trigger on selling my managed RRSP investments which are doing so well right now.

    Last year I followed the CCP model portfolios and invested in ETFs in both my TFSA and RRSP accounts, but I didn’t go all in. I still have some of my early investments tied up in managed BMO Equity ETF Funds. My previous strategy was similar to CCP by which I diversified my investing through an even split between US, CAN & INT’L, and with low MERs. I recently had the BMO ETFs transferred into my BMO self-directed account where I was planing to sell them and pick-up more of the CCP ETFs, however the BMO Equity ETF Funds are all outperforming my CCP portfolio ETFs. The MER on the BMO Equity ETFs are between 1.05% – 1.17%, which are obviously much higher then the ETFs in the CCP portfolio, but their performance is almost double in all markets US, CA & INT’L.

    So my question really is, should I just sell them and go all in on the CCP ETFs, or hold them as they are experiencing great performance? I do want to just simplify everything … but wisely.

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