Should I switch all at once?

A couch potato investor named Remi sent me the following question:

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.)

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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.