February 8, 2019
So often when we contemplate our investment strategy, we think only about the positives: income from dividends, stock price appreciation, the huge increases in the balances that appear at the bottom of our brokerage statement. It’s all sunshine and rainbows until sometime in late January when we receive the bad news contained in the form 1099-B from our broker. What bad news is that? You made money and Uncle Sam wants his cut. Then when we finally complete our taxes we see the ultimate impact.
Often we buy and sell securities thinking only of the moment without considering the ultimate tax implications of our actions. Certainly, the first thing we should consider is whether we are trading in a taxable or deferred tax account. If you have a self-directed individual retirement account (IRA), you can buy and sell as much as you want and not realize any tax liability until you finally withdraw your funds during retirement. That’s not to say frequent trading can’t impact your returns negatively, but that’s a topic for another article.
When trading in a taxable brokerage account, every time you sell a security, you will have a gain or loss on the sale subject to income tax. The key here is the difference between long-term (defined as holding for 366 days or longer) and short-term (defined as 365 days or less). Short term capital gains are taxed at the taxpayer’s marginal tax rate, which could be as high as 37% under the 2018 tax tables. Long-term capital gains are taxed at a more advantaged rate of 15% for most tax brackets, but can be as high as 20% for the top two tax brackets or as low as 0% for the bottom two tax brackets. This is a significant difference in what you pay Uncle Sam. As an example, we ran a simple model showing the difference in tax affected returns for a simple investment of $1,000 over a 30-year time horizon.
In the base case, we assume the investor purchases a $1,000 index fund that returns a market rate of 8% per year (a very simplistic assumption). By the end of 30 years, the $1,000 investment is sold for $10,062.66 for a long-term capital gain of $9,062.66. At the 15% long-term capital gains tax rate, the tax liability would be $1,359.40 for a net after-tax value of $8,703.26.
For the trader, we assume the same 8% return, but that the portfolio is turned over once a year, resulting in a gain subject to short-term capital gains taxes. Over that same period, the total income tax liability (not adjusted for inflation) was $2,534.31 and the ending net after-tax value of the portfolio was only $6,385.41!
To end up with the same result as the buy-and-hold strategy, the investor would need to consistently outperform the market by 138 basis points every year for 30 years. That may not sound like much, but it is a pretty big challenge for the average investor. The bottom line is that you should always be mindful of the tax implications of your investment decisions to avoid underperformance of your investments, not to mention an unpleasant surprise when April 15th arrives!
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