Switching ETFs: Is It Worth the Tax?

You own an ETF, and you find another one that does the same job for a lower fee. The obvious move is to sell the old fund and buy the new one. But if your fund has gone up in value, selling it means paying tax on the gain. So before you switch, work out whether the lower fee is worth the tax.

The idea is simple. Compare the fee you'd save each year against the tax you'd pay once. A lot of the time the tax is bigger, so switching doesn't pay. And when it does, you can often switch without selling. Both cases are below.

Only the gain is taxed

When you sell a fund, you're not taxed on the whole amount. You're taxed only on the gain, the part that has grown since you bought it.

Say you hold $5,000 of a fund, and $750 of that is gain. If you sell, only the $750 is taxed. The other $4,250 is money you put in yourself, so it comes back to you tax-free. At a 30% tax rate (France's flat rate on investment income, for example), the tax on the $750 gain is about $225. Real return shows how the rate changes from one country to the next.

So the switch costs you $225 in tax today. The real question is whether the lower fee earns that $225 back, and how long that takes.

Is the lower fee worth the tax?

To find out, compare the two fees and multiply the difference by how much you hold.

SPY charges 0.0945% a year. VOO and IVV track the same S&P 500 index for 0.03%. Many people want to switch away from SPY to pay less. But on $5,000, that fee difference is only about $3 a year. Paying $225 in tax now to save $3 a year would take decades to break even, so it isn't worth it. A better move is to keep your SPY shares and buy VOO with new money from now on.

Now a case where switching does pay off. ARKK charges 0.75% a year, and it has shrunk to about $7.3 billion from a much higher level. Switching it for a cheap, broad fund like VTI at 0.03% saves 0.72% a year, or about $36 on $5,000. The tax is still $225, but here the saving pays it back in a few years, and everything after that is yours. The difference from the SPY case is the size of the fee gap.

A rough rule: if the fee difference is under about 0.2% a year, switching a fund you've made gains on usually isn't worth the tax. If it's above 0.3% a year and you'll hold for a long time, it usually is. Expense ratios explains how small fees add up over the years.

Two ways to switch without selling

The tax only applies when you sell at a gain, so the easiest switches skip the selling.

One way is to stop adding money to the old fund and put all your new money into the new one. Your old shares stay where they are, and you pay no tax. After a few months, the new fund is most of what you hold. Your regular contributions do the work, so you never have to sell.

The other way works if you hold the same fund in two different accounts. Some accounts, like a PEA, an ISA, or a 401(k), let you sell without paying tax. In one of those, you can switch straight away. In your normal taxable account, you switch slowly by adding new money, as above. Which fund belongs in which account is a separate question, and asset location covers it.

What if the fund has lost money?

If the fund you want to leave is worth less than you paid for it, things change. Selling now creates a loss, and in most countries a loss lowers the tax on your other gains. So here, switching can save you money.

There's one rule to watch. In the US, the wash-sale rule says you can't count the loss if you buy back the same or a nearly identical fund within 30 days. The UK has a similar 30-day rule. You can get around both by switching to a different fund, such as a total-market fund instead of an S&P 500 fund. France has no rule like this, so a French investor can sell at a loss and buy the same fund back the next day, and still use the loss for up to 10 years.

Selling at a loss to switch can be a good move, as long as you don't buy the exact same fund back where these rules apply.

Don't switch too often

One last thing. Every month there's a fund that's a little cheaper or a little bigger. If you switch each time, you end up buying and selling all the time, and that costs money. Barber and Odean (2000) looked at 66,000 households and found that the ones who traded the most earned 11.4% a year, while the market returned 17.9%. The trading itself is what held them back. It's the same lesson as why most active funds lose to the index: low costs matter more than trying to beat the market.

A switch is worth making when the fee saving beats the tax. It also makes sense if the fund is shrinking and might close (ARKK is a good example), or if it turned out to be wrong for your goal. The rest of the time, it's usually best to leave your funds alone. Even moving from an expensive bond fund to a cheap one like BND only needs doing once.

How Beacon can help

Before you switch, it helps to know what you're paying now. You can sort the screener by cost to find the cheapest fund for what you want, then save a portfolio to see the average fee across everything you hold. That's the number to compare against the tax. Create a free account to keep your funds in one place. Beacon shows you the fees. The tax you work out yourself, using the steps above.