WARNING: Converting an Index Fund to an ETF May Increase Your Wealth

For the young investor, ETFs can be a real tease. They tempt you with their low costs and tax efficiency, only to whack you with commissions when you go to buy them. For those making small, monthly investments, the commission costs alone put ETFs out of reach. It turns out, though, that ETFs can be a real tease to us older investors, too. Here’s the problem, followed by a nifty solution I recently uncovered.

The Problem with ETFs

Through small, monthly investments when I was younger, I’ve built up a substantial investment in a number of index funds, Vanguard’s Emerging Market Index Fund (VEIEX) being one of them. Now that my investments in the fund have grown and I’m not making small, monthly contributions, I would love to sell the fund and buy the equivalent ETF (VWO). The annual expenses are 12 basis points lower, and ETFs generally are more tax-efficient than funds (although VEIEX is a very tax-efficient fund). By tax-efficient, I mean that ETFs generally do not generate yearly capital gains that are taxable, thus, you only pay capital gains tax if and when you sell any of your investments. The problem I have is that selling my investment in VEIEX would trigger substantial capital gains tax. In recent years the fund has skyrocketed, returning 57% (2003), 26% (2004), 32% (2005), 29% (2006) and 23% so far this year. So in the past four and a half years, my investment has more than quadrupled. So selling now would result in substantial taxes.

Converting a mutual fund to an ETF

It turns out that with this particular Vanguard fund, I can convert (not sell) my Emerging Market Index shares into Emerging Market ETF shares without triggering capital gains tax. The reason for this, according to Vanguard, is that the ETF shares are just one of several share classes within the Emerging Market fund. And converting from one share class to another is not considered a sale for capital gains tax purposes, again according to Vanguard. The following is from Vanguard's website:

Shareholders of Vanguard stock index funds that offer Vanguard ETFs may convert their conventional shares to Vanguard ETFs of the same fund. This conversion is generally tax-free, although some brokerage firms may be unable to convert fractional shares, which could result in a modest taxable gain. (Bond ETFs do not allow the conversion of bond index fund shares to bond ETF shares of the same fund.)

Vanguard will charge $50 for each conversion. (This fee is waived for Flagship clients.) Your brokerage provider may charge an additional fee for this service. For more information, contact your brokerage firm, or call 866-499-8473.

Once you convert to Vanguard ETFs, you cannot convert back to conventional shares. Also, conventional shares held through a 401(k) account cannot be converted to Vanguard ETFs.

Note that once you convert to the ETF, you cannot convert back to the index fund (why would you want to?). Also, you cannot convert index funds held in a 401(k) account. You do have to determine whether the conversion is worth the $50 fee. In my case, I'll recover that cost in less than a year, so there is no question that converting to the ETF is a smart move. One final comment. When I first read the above information about converting to ETFs, I called Vanguard to confirm my understanding. The first representative I spoke to told me that the conversion would trigger capital gains tax. It turns out, though, that the person I spoke to did not work in Vanguard's brokerage division, which handles ETFs. When I inquired further, she transferred me to the brokerage division who confirmed that conversions do not trigger capital gains tax. Remember, though, that the conversion has to be within the same fund (e.g., Emerging Market index to Emerging Market ETF).

I hope this mutual fund investing tip has been helpful, and be sure to stop back soon for more wealth-building ideas from The Dough Roller.