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Taxable Investing

2011 May 24

Man filling in tax formsThis article was based on work with my friend Jeffrey Horvitz, who taught me that the details are incredibly important in achieving better after-tax returns.


Better After-Tax Returns
Jarrod Wilcox, October 6, 2003

The best time of the year for thinking about taxes is here, and many investors still have opportunities in the unrealized losses they have left over from the bursting of the recent stock market bubble.  Some of us don’t seem to enjoy tax time and have a hard time integrating it with our regular investment activities.  Yet the US government is generous in its rewards to investors who pay attention to its encouragement of long-term investing through tax law.


Many taxable investors are solely concerned to get better pretax returns when they should be thinking about after-tax returns.  Recently Jeffrey Horvitz and I researched this issue in a new way and published the results in an article on the incremental value of deferring capital gains taxes (“Know When to Hold ‘Em and When to Fold ‘Em: The Value of Effective Taxable Investment Management”, Journal of Wealth Management, Fall 2003, pp. 35-59).


We compared various sensible strategies to the all too typical case of a taxable investor completely insensitive to the importance of managing for after-tax return.  This unfortunate investor turns over his or her portfolio 100% annually, spread equally over the calendar months.  We used 1000 realistic scenarios bootstrapped from actual history for the S&P 500 index as our measuring tool.  Our purpose was to ballpark estimate the benefit of paying attention to taxes under very realistic conditions involving risk, trading costs of 0.5% round-trip, short and long-term capital gains taxes, the necessity of loss carry-forwards, inability to match losses against gains outside the portfolio, dividend taxes and reinvestment, all using the most recent tax rates.  What follows summarizes our findings.  Although the principles are general, our quantitative estimate of benefits assumes you are in the top tax bracket.  On the other hand, we did not include added benefits from managing returns after em>state taxes.


We also didn’t consider any specialized legal vehicles, or any strategies that would change the character of pre-tax returns.  So what is left?  Plenty.  The four main areas for attention are:


  • Avoiding short-term gain treatment
  • Extending long-term holding periods
  • Selling low liability tax lots first
  • Setting aside buy-and-hold assets to be passed to heirs and charities.


The Benefits of Deferring Capital Gain Realization


Short-Term Capital Gains: You are taxed at your ordinary income tax rate, approximately at 35%, for any gains realized through a sale before one year has passed.  If you can wait a bit longer, you will reduce your tax to 15% of the gain.  It is fine, sometimes even useful, to sell stocks that are underwater less than a year after you bought them.  As a private individual, unless you have a matching short-term loss carry-forward, it is almost always a terrible idea to sell stocks at a gain before waiting more than a year after a purchase.


Of course, the assumption behind that statement is that you will not soundly expect to cover both your trading costs and the extra tax with the prospective higher rate of profitability on the new replacement asset.  That seems a very reasonable assumption for nearly all investors.


In the following section, I’ll quantify the very substantial median benefit of avoiding short-term gains treatment from a thousand realistic scenarios.


Extending Long-term Capital Gains: If you think you will probably need to sell your stocks in less than ten years, at current low long term capital gain tax rates of 15% you probably won’t benefit from this second strategy, but it is worth understanding even so, because the principle will come up later.  (Of course, if you are investing for a taxable corporation like an insurance company, with a gains tax rate of 34%, the benefits come somewhat faster and are considerably greater than shown here.) For individuals, the benefits are very slow to build, because they depend on the compounding of extra earnings you get on the extra capital you have to work with though deferring the payment of the long-term capital gains tax.  They are quite significant for very long holding periods, as when you invest at 30 and can hold until age 70.


Many people find comfort in realizing a gain, that is in selling a stock that is priced much higher than when they bought it.  Sometimes that makes sense, either to get greater diversification, or because you have good reason to believe that the current high price is temporary.  But what if you have plenty of diversification and no great skill in judging when a stock has reached its peak?  The exhibit below shows what happens in comparison with our tax-insensitive investor who has 100% turnover as you reduce your annual turnover levels and wait longer until final liquidation.  (I assume you will also pay taxes at liquidation;  the exhibit shows net annual benefits expressed as increments to annualized return for the whole life cycle of the investment portfolio.)

Chart of benefit of not realizing a capital gain

Ignore that no benefit is shown in the first year — that is an artifact of our simulated scenarios regarding exactly one-year as a short-term gain.  Look instead at the benefit for the next milestone, the three-year mark.  The median buy and hold portfolio improved its after-tax return by about 0.9%  over that of the tax-insensitive investor!  Including 0.25% one-way trading costs, this is a good estimate of the prospective benefit of avoiding short-term gain realization.  Suppose average annual stock market pre-tax price return is 8%, and short-term tax rates are 35%.  The tax-insensitive investor will receive 5.2%, in addition to after-tax dividends, while the more savvy investor who keeps turnover down to, say no more than 10% a year, will receive 6.0%.


Over most of the range of possible activity, the tax benefit of lower turnover is roughly linear. This is the impact of reducing after-tax trading costs and avoiding short-term gains tax treatment.


However, look what happens when the very low turnover rate of 5%, roughly the level of an index fund, is reached.  The median benefit begins rising with time until final liquidation!  It is this upward slope that is the benefit of extending holding periods beyond the one-year minimum.  For a true buy and hold strategy with no turnover, it amounts to a median further 0.3% for a 25 year old who waits until age 75 to sell.  This benefit would be considerably larger but for dividend reinvestment, which has the effect of shortening the average holding periods over long investing lifetimes. (Again, for a taxable corporate investor, the slope would be considerably steeper than shown here because of higher effective tax rates.)


The preceding exhibit shows the median result for 1000 scenarios.  But if the market happens to do well, you will save more by paying attention to taxes.  If it does poorly, you will save less.  Note the table below.


Tax alpha for a buy-and-hold investor

Selectivity in Choosing Which Tax Lots to Sell: Perhaps you feel that you will not be able to maintain the exceptionally low turnover rates to get the long-term upward slope in after-tax annualized return increment shown in the preceding exhibit.  All is not lost.  Not even close.  At any given point in time, there will be a wide variety of capital gain liabilities in your investment portfolio.  The government permits you, as well, to keep track of different lots of the same stock you bought at different times.  Other things equal, that is if you can maintain a reasonably diversified portfolio and don’t have enough forecasting skill to predict future returns, it always pays to sell first the security with the lowest tax liability.  Even if you do not have any current gains to offset, this banks a loss you can use to offset current or future realized gains in other securities.


In the extreme, say a loss on the order of 30-50% or more, you may even find it useful to realize a loss mainly for tax purposes.  I now have a little trouble with this extreme case, often labeled tax loss “harvesting,” a term generally used today that I believe I coined years ago, because it goes beyond the intended purpose of the government in encouraging long-term investing.  However, as there is no practical way of telling when an investor may have some non-tax purpose in mind when making a sale, the government has in effect permitted tax loss harvesting, and one would be remiss in not offering it as a possible strategy.


Even when stocks are not sold primarily for tax reasons, however, it is advisable, from a tax perspective to hold on to your winners and sell your losers.  How big is this effect?  Very big.  Research with even the limited variety in price to cost-basis ratios for different tax lots of the same S&P 500-like stock bought at different periods indicates substantial benefits.  (If the portfolio included different stocks from widely varying industries, market capitalization, and growth characteristics, as well as international stocks, the potential after-tax return benefit would be increased from that to be shown here.) The exhibit below shows that you can get considerable compounding tax benefits of long-term holdings even at substantial rates of annual turnover by selective selling by tax lot.

chart showing benefit of selling high cost tax lots first

Note that now even the median result lines with high rates of turnover have upward slopes with the period to liquidation.  Over time, the effect of selling the lowest tax liability tax lots first is to concentrate turnover into a sub-portfolio of newer purchases, and to set aside a buy and hold portfolio.  While this can be a concern if the buy and hold portion is concentrated in one stock, it will typically not be a big problem if the buy and hold portion is itself diversified, either because it is composed of index
funds, or because the initial portfolio was “over-diversified.”


Buy and Hold Portfolio Set-Aside for Heirs and Charities: Stocks willed to charities are not taxed.  This means that you get the full benefit of avoiding all short-term and long-term capital gains taxes.  Your annualized after tax return is improved by 15% of the annual price return, plus avoided trading costs, as well as any short-term gain taxes.  These benefits are, with 8% price returns and 0.5% round-trip trading costs, worth over 2% a year, a huge increment for the buy-and-hold investor when compounded over decades.  But even if you leave your estate to heirs and they must pay the highest possible one-time estate tax, the median increment to after-tax returns is approximately 1.3%.  You should read the Journal of Wealth Management article previously cited if you want to gain a clearer understanding of how this works.


The Challenge to Active Management


There is nothing wrong with seeking better pre-tax returns if you have the skill for it, or if you derive appropriate pleasure from the activity.  However, the threshold for the skill you need is not zero, but the kind of increments in after-tax returns available from better tax management through passive strategies.  If you must pick stocks, concentrate on picking good ones for the long-term that you can hold onto, and volatile ones for the short-term for which tax loss benefits will be readily available.  And if you want to leave a much bigger estate to your family and favorite causes, set aside a buy-and hold portfolio, perhaps in index funds, as early as possible.