Don’t Miss Out, You’ll Regret It (Part 3)

Key Points

  • By holding a profitable investment for over a year before selling, an investor has the opportunity to significantly reduce the amount of taxes that he or she will have to pay.
  • By holding an investment indefinitely, an investor can hold off on paying taxes indefinitely.
  • By deferring the payment of taxes, capital can grow exponentially faster than otherwise.

There’s a reason why buy and hold investors tend to do well over the long-term. And it’s not so much to do with picking the right assets to invest in; but rather, it has to do with how stocks are taxed, in general. Knowing the finer details of how taxes work can save you big time. Here’s how.

Scenario Time

In a typical taxable investment account (we’ll cover tax-advantaged accounts later in this series), investment income is subject to taxes on interest, dividends, or capital gains (as outlined in Part 1 of this series). As previously discussed, interest, ordinary dividends, and short-term capital gains are taxed at an individual’s marginal tax rate (which caps out at 37%), while qualified dividends and long-term capital gains are taxed at a lower long-term capital gains rate (which caps out at 20%). So let’s explore the impact that these different tax rates can have on an investment account over time.

When it comes to investing in stocks, the short-term capital gains rate applies to investments that are held for less than a year; while the long-term rate applies to investments that are held for longer than a year. The federal government wants to incentivize investors to hold onto positions for the long-term, and thus the long-term tax rate is substantially lower than the short-term rate.

Scenario A (short-term rate): You invest $10,000 into a stock and sell after just under one year for $11,020. At the end of this period, you have earned $1,020 in pre-tax profit, and you pay short-term capital gains on this amount. Since your short-term capital gains rate is 37% (which is also your marginal tax rate), your after tax gains on your original investment is $643; which once again represents an after-tax profit of 6.4%.

Scenario B (long-term rate): But had you held onto your investment for just a few more days so that your holding period was just over one year, you would have paid long-term capital gains instead. As such, your long-term capital gains rate is only 20%, so your after tax gains on your original investment is now $816; which represents an after tax profit of 8.2%. So the very first thing to consider is that if your holding period is close to a year already, think about holding on for a bit longer to lock-in a lower tax rate. In this case, it’s an easy $173 (tax free, no less) in your pocket by taking this small effect into consideration.

Thus, the First Rule of Tax Efficient Investing is that all else being equal, aim for investments where the profits can be taxed at the lower long-term capital gains rate.

Scenario C

But let’s consider another scenario that is often forgotten. Let’s say that the $10,000 you have already saved is for retirement, so you don’t have any need to spend this money or any of its associated gains for a very long time (say 45 years). In this case, let’s say after your first year, your $10,000 is now worth $10,643, which presents a return of 6.43%, which also happens to be the average 45-year return for the S&P 500 Index (after adjusting for inflation).

Now you have two options: you can sell and find another investment for the following year, or you can hold onto your investment and not sell at all. If you don’t sell, you pay zero in long-term capital gains. In finance, this is known as an unrealized gain, since you have yet to sell your position. In Table 1 below, we see examine these outcomes in more detail.

Three ScenariosScenario AScenario BScenario C
Starting Principle$10,000$10,000$10,000
Pre-Tax Return10.2%8.0%6.4%
Pre-Tax Gain$1,020$804$643
Pre-Tax Ending Principle$11,020$10,804$10,643
Tax Rate37%20%0%
After-Tax Return6.4%6.4%6.4%
After-Tax Gain$643$643$643
After-Tax Ending Principle$10,643$10,643$10,643
Table 1. Impact of Taxes Across Three Scenarios (High Tax, Low Tax, and No Tax)

So let’s dig into the analysis presented in Table 1. Once again, Scenario A represents the case where an investor pays short-term capital gains, Scenario B represents the long-term capital gains case, and Scenario C represents the zero taxes case. What we are showing in this table is how much in pre-tax return each scenario would have to generate in order to end up with the same after-tax return in all three scenarios.

Accordingly, in order to generate an 6.4% after tax return, an investor in Scenario A would have to generate a pre-tax return of 10.2%, while an investor in Scenario B would have to generate a pre-tax return of 8.0%. Thus, an investor in Scenario B would have to generate 18% more in profit to match the after-tax return of Scenario C; and an investor in Scenario A would have to generate 59% more in profit to match the after-tax return of Scenario C.

Think about it this way: a short-term investor must earn 59% more on every dollar to match the return of a tax free investor. Make no mistake: this is no easy task.

As we have noted in the past, the average return for the S&P 500 Index over long periods has been around 6.4% (after adjusting for inflation). Thus, if you passively invested in a mutual fund designed to match this index, you would expect to earn about this level of return over time. And if you never sell your position, you’ll never have to pay capital gains due to appreciation on your investment.

Note: you still may have to pay a small portion in taxes for any dividends and capital gains due to internal rebalancing within the index, but most of your gains will ultimately not be taxed (until you liquidate your position).

However, if you decide to actively manage your portfolio you will be subject to either short-term or long-term capital gains each time you exit a position. If you are able to hold on to each position for at least a year, you’ll only pay long-term capital gains, but this also means you might need to generate about 18% more in profit on each trade on average to just keep up with the buy and hold strategy mentioned above.

And if you are a short-term trader that can’t manage to hold onto any positions for even one year, then you’ll essentially only pay short-term capital gains. And this means you now must generate about 59% more in profit on each trade on average to just keep up with the buy and hold strategy mentioned above.

Both of these active approaches are hard to pull off over one’s lifetime. As we have noted in the past, most active managers do not beat their benchmarks over time. If we are to factor in the impact of taxes into all this, the chances of coming out ahead goes from not likely to almost impossible, especially if an investor ends up paying mostly short-term capital gains.

Never Sell

This brings us to our Second Rule of Tax Efficient Investing: never pay taxes at all by simply never selling (i.e., invest as if you’re Investing Forever). But isn’t the whole point of investing to generating profits to buy nice things? True. But my point is for capital that doesn’t need to be spent, it’s far better to let it grow without paying taxes on gains for as long as possible. In the next post of this series we’ll compare the performance of these same three scenarios, but this time over the investing lifetime of an individual.