Question

Assume you invested $100,000 in a balanced mutual fund 5 years ago through a non-registered account. Despite 2.25% in annual fees (MER) embedded in the fund, market gains brought the total value of your investment to $150,000. You want to reduce your costs by switching to a low-cost ETF which charges 0.25% in fees for an annual fee reduction of 2%. You want to know if it is worth switching it if you plan to hold onto it for 10 year. Use the following assumptions to answer the series of questions below:

·       Your marginal tax rate is 40%

·       You pay for your capital gains from the proceeds of the sale and invest what's left over (including original contribution amount) to the ETF.

·       Both the mutual fund and ETF will return 6.25% each year before fees.

·       Only account for the capital gains realized when selling the mutual fund (ignore any commissions, deferred sales charges, dividends, etc.).

1. Explain the tax implications of selling the mutual fund.

2. Calculate how much you would own in taxes upon selling your mutual fund.

3. Assuming you sold the mutual funds for $150,000 and paid taxes on the capital gains - how much will you be able to invest in the ETF?

4. How much would you have in 10 years if you kept the mutual fund? (This means you did not sell it and pay taxes. Instead, you kept it and left it in the account to grow).

5. What would your after-tax gain be if you kept the mutual fund? (Note, you need to calculate the final amount in the account, subtract taxes and the initial investment amount).

6. How much would you have in 10 years if you sold the mutual fund and used the after-tax proceeds to invest in the ETF?

7. What would your after-tax gain be on the ETF? Base this off the initial investment of $100,000. Hint: you need to account for the tax you paid when selling both the mutual fund and the ETF.

8. Explain which option is the best choice and justify your answer; a. keeping the mutual fund, b. selling mutual fund to buy an ETF.

Answer 1

Ans 1.	On selling the mutual fund capital gain tax will be levied on the gain arising from sell of mutual fund.
Ans 2.	Tax on selling the mutual fund =	(Sale price of mutual fund - cost price)*tax
		($150,000 - $ 100,000)*.40
		$20,000
Ans 3.	Amount left after selling the mutual fund and paying taxes
	= 150000-20000
	= $130,000
Ans 4.
a	Current value of Mutual fund	$150,000
b	ROR	6.25%
c	Annual fees	2.25%
d	net return (b-c)	4.00%
e	Time (years)	10
	Amount a*(1+(d/100))^e	$222,036.64
Ans 5.	After-Tax Gain
	Final Amount	$222,036.64
	tax (222036.64-100000)*.4	48,814.66
	Initial Investment	100000
	After-Tax Gain	73,221.98
Ans 6.
a	Current Investment in ETF	$130,000
b	ROR	6.25%
c	Annual fees	0.25%
d	net return (b-c)	6.00%
e	Time (years)	10
	Amount a*(1+(d/100))^e	$232,810.20
Ans 7.	After-Tax Gain
	Final Amount	$232,810.20
	tax (232810.20-130000)*.4	41,124.08
	Initial Investment	100000
	After-Tax Gain	91,686.12
Ans 8.	Option B is the best choice i.e., selling mutual fund and investing in ETF, as the after gain tax is higher in ETF