Key Points

  • By minimizing the impact of taxes, and buy-and-hold investor can outpace other investment styles.
  • Over the investment lifetime of an individual, this can more than double one’s upside potential.

Small Difference, Big Deal

In the past post of this series, we noted the significant tax consequences of different investment styles. A short-term investor (i.e., one that typically holds trades for less than one year), will be primarily subject to short-term capital gains taxes. A long-term investor (i.e., one that typically holds trades for longer than a year), will be primarily subject to long-term capital gains. And a buy-and-hold investor (i.e., one that typically buys and holds for many, many years), will be primarily subject to minimal taxes, no almost no capital gains.

As far as taxes go, the short-term capital gains rate as of 2019 caps out at 37%, while the long-term capital gains rate caps out at 20%. Over a lifetime of investing, these differences can add up.

Investment Life Tax, Tax-Adjusted

Table 1 below (first introduced in Part 3) shows the performance over one year of three different investment scenarios. Scenario A represents the purely short-term investor that pays the highest short-term capital gains rate. Scenario B represents the purely long-term investor that pays the highest long-term capital gains rate. Finally, Scenario C never pays anything in capital gains because this investor is the ultimate buy-and-hold investor. This individual NEVER sells, and thus never pays this type of tax.

Scenario A Scenario B Scenario C
Starting Principle $10,000 $10,000 $10,000
Pre-Tax Return 10.2% 8.0% 6.4%
Pre-Tax Gain $1,020 $804 $643
Pre-Tax Ending Principle $11,020 $10,804 $10,643
Tax Rate 37% 20% 0%
Taxes $377 $161 $0
After-Tax Return 6.4% 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)

As previously discussed, 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.

Put simply: 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).

Never Sell (The Details)

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.

Scenario A Scenario B Scenario C
Starting Principle $10,000 $10,000 $10,000
Pre-Tax Return 6.4% 6.4% 6.4%
Pre-Tax Gain $640 $640 $643
Pre-Tax Ending Principle $10,640 $10,640 $10,643
Tax Rate 37% 20% 0%
Taxes $237 $128 $0
After-Tax Return 4.0% 5.1% 6.4%
After-Tax Gain $403 $512 $643
After-Tax 1 Year Later $10,403 $10,512 $10,643
After-Tax 45 Years Later $59,226 $94,589 $165,431

Table 2. Impact of Taxes over 45 Years (High Tax, Low Tax, and No Tax)

Over an investment lifetime, we can getter a more clear picture of just how much difference taxes can make. A Scenario A investor is only left with $59k, while a Scenario B investor would be left with about $95k and a Scenario C investor would be left with about $165k. The only difference is taxes in all three scenarios.

There are many ways to become a Scenario C investor. As mentioned, you can buy an investment, and never sell. But there are other ways as well. We’ll discuss all this in more detail in Part 5 of this series.