It seems simple but investors frequently underestimate the impact of taxes on investment returns. They ignore capital gains taxes until they have to pay them. This practice greatly inhibits the realization of your real-life expected return.
Example
Deferring a gain by selling a stock after you have held it for more than a year, chaning it from short-term to long-term, makes a big difference.
Take a $2,500 gain on a $10,000 investment: you'll pay about $1,000 in taxes if you sell in less than a year, but only $500 if you sell after a year1. That's a 20% after-tax return versus a 15% after-tax return — just for waiting a little longer to sell!
It's What You Keep, Not What You Earn
How sophisticated you want to get is up to you. With a separately managed account (SMA), we can do something as simple as sell poorly performing securities before the end of the year, defer selling winning stocks until later, or even develop a tax loss harvesting strategy that may balance gains and losses to produce no taxes at all while still taking out cash.
Berk has a long history back to the 1980s of managing private taxable investors' tax liabilities. We know that it's what you keep, not what you earn, that contributes to your life-time total return.
We are not tax advisors but we are well equipped to work with your tax advisors on any strategy to minimize your tax liability and maximize your life-time return.
Mutual Funds Often Surprise Investors with Taxes
Taxes affect stocks and mutual funds differently. A mutual fund is required by law to distribute all of its realized capital gains each year and is prohibited from distributing any losses. You incur a tax liability when the fund distributes these gains.
These mutual fund tax distributions are controlled by the fund, not by you.
To make matters worse, you may find yourself with a tax liability from the capital gains taxes the fund must distributeeven if you have an economic loss in the fund itself.
And, if you made a profit from the fund, you still have to pay capital gains tax when you sell the fund shares — separate and in addition to the taxes distributed by the fund. Ouch! All these taxes really affect your after-tax real-life return.
Paying for Someone Else's Gains!
Quantifying the Effects of Ignoring Taxes
John Bogle of the Bogle Financial Markets Research Center has calculated that the average managed mutual fund generated tax costs of more than 30% of their total pre-tax return over the period 1980-20052. The average actively-managed fund surrendered 1.8 percent of that annual 10% return to taxes, bringing the after-tax return to 8.2 percent. Over 25 years that reduced the value of $1000 invested from $9,820 pre-tax to a lousy $6,170! Taxes matter a lot.
Additional, a study by Morningstar found that the average large blend mutual fund generated an annualized return of 9.24% for the ten year period through 20033. The after-tax annual return for a shareholder who owned the average balanced fund for this period was 7.36% (assuming the highest Federal tax brackets for the investor). This means that the investor’s after-tax return is almost 2% per year less than the pre-tax return — even if the investor never sells a share of the fund. Ouch!
1Assumes a 40% tax rate for short-term gains and a 20% tax rate for long-term gains. Of course, federal, state and local taxes, along with an investor's individual circumstances will cause these numbers to vary.
