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It seems that converting my (non-IRA and non-Roth IRA) Vanguard mutual funds to the corresponding or equivalent ETFs is a smart tax move to make.
However, then I read this in Vanguard’s information about making the conversion.
By making the conversion, I will be giving up the average cost basis of the shares I had purchased years ago, and applying the FIFO (First In First Out) cost basis.
This is what Vanguard says:
“If you are already locked into the average cost method by a sale, transfer, partial conversion or other disposition of your Vanguard mutual fund shares, we’ll have you exit the average cost method for any eligible shares of Vanguard mutual funds and apply the FIFO cost basis method prior to this conversion to the ETF share class. This means share lots acquired prior to the conversion will be listed individually with the averaged cost.”
I don’t want to make the conversion from Vanguard mutual funds to Vanguard ETFs if it will be a bad decision from a tax perspective when it comes to changing the cost basis to FIFO.
I need some help from the Humble Dollar community. What are your thoughts folks?
I converted my Vanguard mutual funds to their companion ETFs a few years ago. One significant reason was that Vanguard largely caused large capital gains distribution in its Target Date Funds at the end of 2021. It didn’t have an impact on investments held in IRA accounts, but it did create an unwelcomed surprise for those holding the funds in taxable accounts. This article from Morningstar details the problem and also mentions of similar adverse tax consequences in other mutual funds run by J.P. Morgan, Fidelity and T. Rowe Price.
This article from State Street Global Advisors explains why ETFs are more tax efficient than mutual funds.
While large index funds typically do not have large capital gains distributions, I believe that it is prudent to own the investment in the ETF form when available.
I have always used the Specific Identification tax lot method for my former mutual funds and my current ETFs. However, when I converted my Vanguard mutual funds to their ETF equivalents, they were brought over at an average cost per share. Any subsequent purchases have been recorded with the Specific Identification tax lots. While I was disappointed that the initial individual tax lot information was not transferred over during the ETF conversion in my taxable account, my tax basis was very low, having owned the funds for decades, and it was not a material consideration for me.
Bob, thank you for sharing your experience and insights and the links you provided for me to look at.
Steve:
Interesting that this article appeared today. I JUST (20-30 minutes ago) had this exact transaction placed for my daughter’s account. BOTH of her accounts are IRAs, presently, 1 Traditional Roll over and 1 Roth.
She is 47, and her timeline is a minimum of age 67.
I converted all my accounts at Vanguard Fromm Funds to ETFs in 2013. Today, my costs are determined by “Min/Max.”
If you are in it for the long haul, average coasts become irrelevant. When it goes to your beneficiaries, they get the step up in basis, so who cares?
Good point. The beneficiaries will get the step up in basis so it will not matter. Thank you
I closed my vanguard accounts several years ago due to awful customer service and transferred the mutual funds to Schwab. I left them alone since investing more would incur a hefty fee. I started buying the equivalent ETFs as part of my regular investment program. It has worked out great.
Thank you for the information.
Are you already locked into the average cost method for one or more funds? Most likely this would be due to sales using average cost. Actually it doesn’t seem to make any difference, as the average cost is still used on the ETF lots.
Thank you for your input.
I converted all my Vanguard mutual funds to ETFs a few years ago. Prior to the change my cost basis on all was SpecID, and the conversion produced tax lots with different prices, which is good for taxes.
I recently converted my Vanguard mutual funds to the equivalent Vanguard ETFs. My reason was so if I ever decided to transfer these holdings from Vanguard to another brokerage I’d be sure there would be no problems with the new firm accepting them.
As I’ll likely hold these funds in line with Warren Buffet’s favorite holding period (“forever”), I wasn’t as concerned with the cost basis method. Of course, when my “forever” ends, my heirs will get a stepped up basis.
Andrew, thank you for sharing your reasoning on doing the conversion.
I was under the impression that Vanguard mutual funds did not report much in the way of capital gains due to a patented method of handling trades. An online search produced this. Were there other taxes that concern you?
Thank you very much for the link describing Vanguard’s system to avoid taxes on mutual funds/ETFs. I have heard that ETFs are considered to be a better vehicle for owners when it comes to taxes.
That is true for mutual funds in general. It is not, according to my reading, true for Vanguard mutual funds that have corresponding ETFs. Try this.
Thank for the second link w/ some great information.
How timely! I am also considering converting the Vanguard mutual funds to equivalent ETFs without tax consequences. Luckily, six out of seven of my mutual funds have equivalent ETFs. Hopefully, the ETFs are more tax efficient than the mutual funds. I’ll investigate tax/distribution data of each ETF from Morningstar, but I have no clue on how changing the average cost method to FIFO method will affect future taxes. Perhaps we can inquire with Vanguard why they want to force this switch in the first place and what would be some of the consequences of this switch in taxes. Hopefully it’s insignificant.
I did not get any notice from Vanguard requiring me to convert to ETFs.
I just thought it might be a good idea because ETFs have the reputation of being more tax friendly for investors. Thank you for your response.
I have held primarily the Vanguard S & P funds in the past. The expense ratio for those mutual fund class is currently 0.04% and for the ETF class is 0.03% per Morningstar and both are listed as having a 2% turnover. I have owned both in my time as an investor and the difference as a buy and hold investor is nominal for me. My holdings have lately all been in traditional IRAs or Roth IRAs or 401(k) type plans and not in a taxable brokerage account.
The reason many like the ETF class is the ability to lock the purchase and sales amounts at the time of trading and not the end of day that occurs with the mutual class. For me I prefer the mutual fund class end of day settlements as it helps keep me shooting myself in the foot by timing the market.
The only compelling reasons that jumps into my mind for me to convert is if I was choosing for all my mutual fund class investments to leave Vanguard to another broker, I was planning to gift shares in kind to family whose brokerage firm is not Vanguard or for some investors if they were planning a in kind gift to a Donor Advised Fund (DAF) and the mutual fund class does not transfer in an efficient manner to the DAF.
William, thank you for taking the time to respond to my question. Each of your paragraphs contains valuable information that I am using to help me come to a decision.