The last few posts have explored the decision process of whether to DIY invest and/or use an advisor. The balance of cost savings vs the potential value of using an advisor varies. Many people start by using a “free” advisor with high-fee mutual funds. That is better than doing nothing, but a robo-advisor or asset allocation ETF can easily beat that. You must learn about investing basics whether you decide to DIY or use an advisor because you must participate and be able to spot bad advice. You might realize that you are suitable for DIY investing and could have saved millions with minimal effort. Even if you are a good DIY investor, there are still times when using an advisor is helpful and can be cost-effective. This week, I tackle some of the reasons why people do not make a switch. Even when they should.
It is very common for people to switch between different investing and advisor models at some point. A common early switch is from the high-fee proprietary mutual fund model to a lower-cost DIY model. Or even to a slightly lower cost, but much better value full-service advisor. Others make the leap to DIY investing from full-service firms. Even if it is ultimately a good decision, change is hard for most people.
One of the barriers that deter people is the fear of paying capital gains taxes. While no one likes to pay taxes, you will pay capital gains taxes eventually. In this post, I will explore whether realizing capital gains earlier than expected can be offset by improved performance moving forward. I will use my lower DIY fees vs capital gains tax calculator to illustrate some cases.
Common Barriers to Switching Advisors
Transferring your portfolio from a high-fee advisor/fund model to low-cost index investing or an advisor with a better value proposition can be relatively painless. Still, several barriers deter people from taking the leap.
Breaking up is hard to do.
Some people worry about an awkward discussion with the advisor they are leaving. Most advisors are likable people, and you are severing a relationship from a role they find satisfaction and profit in. Some will even be offended because they feel that they have experience and skills that cannot be easily replicated by a layperson. Just remember, due to the paradox of skill and efficient markets, even highly skilled managers have a hard time matching an appropriate index. It isn’t a personal failure of them – even though they may see it that way.
They may trot out a carefully selected time period or comparator fund to show you, but carefully curated data of rolling ten-year periods show that over 90% of active managers underperform and past periods of good performance do not predict future good performance. Provide them with data if you want, but you don’t need to be their therapist.
A well-informed professional advisor will acknowledge the data about investing, and try to use their value as a coach and planner to convince you to stay. That may be a reasonable reason to stay if they are providing great value and convenience net of costs. You’ve probably thought of that already though. Perhaps you are moving to an advisor that provides better value to complement your needs and deficits.
Most would not hesitate to leave if the roles were reversed. Advisors often switch firms or get bought out. Similarly, it is a business decision for you.
There is another important thing to be aware of: you don’t have to have that discussion if you really don’t want to. After you open your discount brokerage account, you have your new brokerage contact the old one and arrange the transfer directly. You must initiate the process through the new brokerage anyway (not the old one). They will deploy Schrute if required.
Taxes scare people, but may not matter.
One of the ways that banks get their hooks into you is by using proprietary funds. Those cannot be held anywhere else. So, you would need to do a transfer “in cash”. That means that they sell the funds and move the cash over. If they are ETFs or non-proprietary funds, they can often be transferred “in kind”. That means not sold. Just transferred over. The advantage of that is that you can then sell the ones you want to, when you want to, in your new account. That way, you don’t miss time in the market by sitting in cash. It may also help manage capital gains taxes.
Capital gains taxes do not matter in tax-sheltered accounts, like an RRSP or TFSA. So, there is no tax-deterrent to transferring to a new brokerage. The important thing is to ensure it is a straight TFSA to TFSA or RRSP to RRSP transfer. Not taking the money out to a personal account and trying to re-contribute it.
So, taxes may not matter if you can do a transfer “in kind” or if it is a direct transfer between tax-sheltered accounts.
Tax in Non-Registered Accounts
Telling clients that they will lose a bunch of money to tax by realizing capital gains in tax-exposed accounts is a common technique used when trying to “save an account”. With capital gains in a taxable account, there is indeed going to be some tax. However, what is often not made clear is that capital gains are going to be taxed eventually when your holdings are sold. You aren’t necessarily paying extra tax, but you are losing tax deferral.
Deferring tax is helpful because the amount of money saved by not paying tax now stays invested and growing. Further, realizing a large capital gain could bump you up tax brackets higher than your usual. Realizing personal gains over $250K/yr may even increase the amount of the gain that is taxed. A higher current tax rate and low future tax rate (like potentially in retirement) boosts the benefit of tax deferral.
There are also a couple of other tax nuances that may factor in. Advisor fees for taxable accounts are deductible against income. That attenuates their effective cost by paying it from “pre-tax” income. However, it is still because you have less net income (after the fees) to tax. Corporations also add a layer of complexity. Fortunately, someone with a corporation can potentially use realized capital gains to boost corporate tax deferral by paying out a capital dividend instead of more highly taxed regular income. That will have to wait for another post. I will stick with personal accounts for this one.
Realizing capital gains earlier than you otherwise would have may result in a tax hit. However, you are doing it to improve your portfolio performance moving forward. Hopefully, that improved growth boost overpowers the upfront tax hit.
Common Case of Tax Concerns
I will illustrate using a common situation. Someone with a moderate income of $100K/yr from working and a large unrealized capital gain. This could easily be someone who has been a saver and investor for a long time. Spilling over their registered account room and growing a big non-registered account. Their baseline income puts them into the lower half of the tax brackets with a marginal rate of 31.48% in Ontario. They have managed to invest $167K over the years and that grew to $500K for a $333K capital gain.
It took decades to get there using high-fee retail mutual funds. They also didn’t get much advice or support along the way. Good coffee though. They are distraught because they now realize how much more they could have had if they’d DIY invested. In fairness, DIY investing became much easier over the last few years due to asset allocation ETFs compared to when they started investing. They invested through their bank branch like most Canadians did, but are now ready to make a change.
Their investment timeframe is their lifetime, and this hopefully means plenty of years left to take advantage of lower fee-drag.
After initiating the transfer, their bank advisor called to tell them that they were making a mistake. Not only will they not benefit from their professionally managed funds [cue Dwight Schrute: “False!”], they will pay a bunch of capital gains tax.
Should they give the advisor more of their money? Or some Kleenex?
Double Whammy: Bumping Tax Brackets & Inclusion Rate
The tax is not insignificant in this case. A capital gain of $333K will exceed the $250K/yr personal threshold. That means two-thirds of $83K will be included in taxable income plus half of the $250K. Adding that $181K included capital gain plus their dividends from their mutual funds to the $100K earned income bumps them up to the highest personal tax brackets. They pay an extra $87K in tax, shrinking their portfolio to $413K from $500K. That sounds depressing, but how long would it take for their portfolio to make up for that by growing faster?
The answer partly depends on how aggressively they are invested. The model portfolio that I’ll use in all of these calculations is a 60:40 mix of stocks:bonds. Before fees, it returns 1%/yr interest, 0.5%/yr eligible dividends, and 1%/yr foreign dividends. The capital growth is 5%/yr before 2%/yr inflation is accounted for. I will account for inflation to keep values in “real dollars” representing current buying power. Income (net of tax) gets reinvested and that also raises the adjusted cost base of the investments accordingly.
They are switching from a mutual fund portfolio with a 1.6%/yr MER [not the highest I’ve seen] to an asset allocation ETF with a 0.2%/yr MER. That MER is charged against the income within the fund. So, it reduces the interest/dividend distributions. It is applied against more highly taxed interest and foreign income first.
What You See & What is Hidden
Looking just at that portfolio value that you’d see on your account statements, there is an upfront tax hit from realizing the gains and switching. About $87K and paying that from the portfolio shrinks it to $413K. However, the increased growth rate quickly makes up for that and pulls ahead after 8 years. The gap then grows rapidly due to the power of compounding.
What isn’t readily apparent is that the untouched portfolio still has the original capital gains tax liability baked into it. With the switch strategy, taxes were paid, but that also reset the adjusted cost base to zero. If you were to liquidate the portfolio at any of the time points (for example due to death), then the after-tax value of the portfolio pulls ahead right away and then grows faster.
Retirement Income Impact
Looking at the face value of our portfolio makes us feel richer and the after-tax value hits home the fact that you cannot escape taxes (unless you donate your portfolio to charity). However, what matters most is usually how much income you’ll be able to draw from your portfolio in retirement. That also brings other important factors into play.
First, by reducing fees, the portfolio will be much larger in retirement due to the growth bump. Importantly, this model ignores advisor value. However, a 1.4%/yr boost leaves significant room for being imperfect. The fees also do not disappear during retirement. They continue to eat away at the amount of income you get.
It isn’t all bad news for our sad advisor. In favor of tax deferral from staying, the income during retirement may be lower than it was at year zero. Magnifying the effect not only of paying tax early but also at a higher tax rate than slowly siphoning it out during retirement. Unfortunately for them, that is quickly overpowered by the other factors.
How do those factors interact in our model case?
Let’s say our model investor is going to retire in 35 years. They have $30K/yr of benefits and income outside of their taxable account. Much less than their working income. In that case, the power of compounding easily overcomes the other factors. They have a much larger portfolio. They will pay more tax because of that, but they still have more after-tax passive income. The goal isn’t to pay the lowest fees and tax. It is to have the most money, after fees and taxes.
While we do tend to adapt our lifestyle to our income, let’s assume that they need 80K/yr after taxes to live on. The investor who switched could meet that need without selling anything. The investor that did not would have to sell about $55K/yr to make up for the investment income deficit and cover the embedded capital gains taxes. Here is the screenshot from the calculator.
That snapshot was from 35 years into the future. In reality, there would be a range of time frames as someone draws down from their portfolio each year until they eventually die. That would require a more sophisticated model. However, we can adjust when the snapshot is with my model. Below is a peak just 5 years after the person made the switch. Compounding hasn’t had much time to work its magic yet. In fact, the gross portfolio is still smaller at face value. However, with the lower MER, much more net passive income makes it through. That leaves a smaller gap to fill by selling assets. Plus, selling some units of the ETF has a much lower embedded capital gain because the cost basis was reset when the switch was made.
Spreading Out The Switch
One of the ways to decrease the upfront tax hit is to realize the capital gains over several years while switching. With proprietary mutual funds, that would mean transferring a bit each year. With ETFs or other holdings that can be held by any brokerage, you could transfer it all “in kind”, but sell gradually. If we take the short five-year time frame, that reduces the tax cost. Using the same simulation, but spreading the switch out over 5 years gives a slightly larger portfolio of $568K vs $555K due to less upfront tax. That flows through as more passive income and having to draw ~1K less capital per year to fund the $80K/yr of consumption. That advantage remains similar to the 35-year time frame.
That is a pretty small difference, but meaningful for some people. I would be weighing the benefits of a simple clean break versus spreading it. Plus, the difference may be much less in a situation when the capital gains are small or baseline income large enough that realizing the gains over one year vs several doesn’t bump up the tax rate very much. In that case, the fee savings may readily overpower the tax difference.
Good is Good Enough
The point of this post was to show you that if transferring from an advisor is the best decision for you from a cost and value standpoint, that you should not be deterred. Breaking up is hard to do, but better in the long run. Taxes do not matter for registered accounts. For accounts that are tax-exposed, having deductible advisor fees and deferring capital gains tax does not make up for a massive reduction in fee drag. You may see a tax-hit now, but it is really just now instead of later.
Growing a larger portfolio usually means more tax in the end. However, it also means more money in your hands after the fees and taxes are accounted for. That is what matters.
Corporations add a layer of complexity. That is also used to scare people. However, from the capital gains tax aspect, it should also not be a deterrent due to the ability to pay out a capital dividend. I will expand on that in a future post.
Another great article, Dr. Soth.
Thanks! I get asked about this one all the time. Hopefully, it helps people make changes for the better.
Mark