Taxes Sure Take a Bite

I visit Morningstar’s home page almost every day. I love their data and like about one-third of their qualitative written commentaries. Despite being a daily visitor, I noticed for the first time yesterday a ‘Chart of the Week’ and decided to check it out.

Since I was unable to get a copy of the image, I strongly urge you to click here to check out the chart yourself.

Essentially, the chart shows just what a dramatic impact taxes can have on investment returns. Their analysis shows that stocks have earned 10.1 percent per year from 1926 through 2013, which is consistent with all of the research that we see and use.

Then they apply the tax code as it existed on dividends, interest payments and capital gains assuming an annual income of $110,000 adjusted for inflation throughout time.

They find that taxes reduced returns by 2.0 percentage points per year for stocks and 2.1 percentage points per year for bonds. They show the growth of a dollar and when you cut two percent out of returns for 87 years, it has a massive impact on the final value.

The bad news is that taxes do really take a bite out of returns and the impact over time is substantial.

But there is some good news. First, I think that their estimates of the tax consequences are too high. Second, you can shield some or all of your net worth in tax-deferred or tax-free accounts.

Regarding their estimates, they assume that you turn over the entire stock portfolio every five years, which generates a fair amount of capital gains.

I looked at the pre- and post-tax returns for the Vanguard 500 index fund since 1976 (on Morningstar’s website) and found that the difference in returns was 1.56 percent. That might not sound like much, but it is 25 percent less annually, which adds up substantially when compounded over long periods.

Also, the Morningstar website that shows the tax-data for the Vanguard fund assumes that you are in the top tax bracket, which means an income of more than $450,000 for married couples filing jointly – much more than the $110,000 that Morningstar assumed when making their chart of the week.

I don’t have a good way to judge their bond numbers, but it makes sense that the tax burden should be higher than for stocks, so I think their two percent number might be fair.

As I wrote back in January, there are a number of strategies that we use to try and mitigate the tax consequences, including asset location (click here for a review) and tax-loss harvesting (actually, I haven’t written about that in a while, so expect to see something soon).

These strategies, along with judicious use of IRAs, 401ks, Roth IRAs and other tax-advantaged accounts (even 529 plans, which I mentioned yesterday) are worthy of your investment dollars.

As much as Uncle Sam may ‘need’ your money, recall the quote from Judge Learned Hand, who said:

‘Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again, the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.’