Taxes and Investment Returns

Often we think about investment as an abstract exercise: simply maximize return at the cost of reasonable risk. We often don't give enough weight to the three real-life handicaps: fees, inflation and taxes. Fees are the most manageable. With enough time and effort one can control of his own investment decisions and reduce fees to simply a few trades a year. Inflation is a double edge sword. The stock market performs best under mild inflation. But high inflation, say above 3%, is definitely damaging to the market. Inflation is something that is a inherent part of the economy and stock market which we can think of as "necessary evil", and which we have the least control. Taxes, on the other hand can have a big negative impact on returns. And it is in our control. The best way to avoid taxes is by using a tax sheltered retirement account. I know that Canada, USA and Britain all have such plans. These plans do not tax the capital gains or dividends while funds are used for investment. But they may tax during withdrawal. These accounts can take only a limited amount of money however, and so there is still the tax question for the funds that cannot be in a tax shelter.

For non-tax sheltered funds, I can think of 4 ways to mitigate taxes:

1. move to a place with a cheaper tax rate
2. reduce one's active income
3. reduce turnover
4. harvest losses.

In the USA, the federal government taxes long-term capital gains at 15%. However, the state can impose an additional tax which can be as much as 10%. So an American could choose live in a state with little or no capital gains tax.

Reducing active income to reduce taxes may seem silly, but there is a good reason to do this. If a person has a full time job and invests on the side, he may be able to achieve higher net worth by focusing on investment full time instead. In this manner, he reduces his fees to a certain extent, and also he improve his investment rate of return (ROR). So, even though initially his income is may be lower, it could result in higher net worth over a lifetime because of a higher compounding ROR.

The last two ways are related to turnover. Turnover is defined as a rate that is the proportion of one's portfolio that is sold and bought in a year. If one has a turnover of 25% that means he turns over his entire portfolio once every four years. The less the turnover, the longer funds can compound before the taxman takes it.

Harvesting losses is one argument for diversification. In this method, an investor with a large portfolio has a large number of holdings, which increases the chances of having at least some losing holdings every year. Thus, he can selectively realize the losses to cancel out the gains. The net result is to reduce the turnover rate that will trigger capital gains.

So far this is all straightforward enough. But I haven't found any detailed analysis of the effect of the turnover on the taxes paid. So I decided to do it myself.

To do this, consider a investor with a hypothetical scenario starting with $1000. We'll compare the effective return after taxes after 25 years for different turnovers. First, assume that he maintains a constant 9% rate of return (ROR) and he turns over the entire portfolio every four years. To achieve, he invests the entire portfolio initially, then he "flip" 25% of the portfolio every year. In this discussion, flip means he sells a quarter of the portfolio pays the taxes and reinvests the remainder. In the first year, he flip 25%, in the second and third year he flips the 25% of the portfolio that he didn't flip before. By the fourth year onwards, he flips the portion of the portfolio that have been in the portfolio for exactly four years. In the last year, the investor sells all.

The following table shows the amount that the investor has after 25 years and the after-tax CAGR in parenthesis.

9% pre-tax ROR

Tax Rate	0%	15%	25%	35%
every year	8623 (9.0%)	6315 (7.7%)	5119 (6.8%)	4143 (5.9%)
every 2 years	8623 (9.0%)	6383 (7.7%)	5202 (6.8%)	4225 (5.9%)
every 3 years	8623 (9.0%)	6447 (7.7%)	5281 (6.9%)	4305 (6.0%)
every 4 years	8623 (9.0%)	6507 (7.8%)	5356 (6.9%)	4383 (6.1%)
every 5 years	8623 (9.0%)	6563 (7.8%)	5428 (7.0%)	4458 (6.2%)
every 6 years	8623 (9.0%)	6616 (7.9%)	5496 (7.1%)	4530 (6.2%)
every 7 years	8623 (9.0%)	6666 (7.9%)	5561 (7.1%)	4599 (6.3%)

And the following tables shows the same for 12% and 15% pre-tax ROR.

12% pre-tax ROR

Tax Rate	0%	15%	25%	35%
every year	17000 (12.0%)	11338 (10.2%)	8623 (9.0%)	6538 (7.8%)
every 2 years	17000 (12.0%)	11546 (10.3%)	8861 (9.1%)	6763 (7.9%)
every 3 years	17000 (12.0%)	11740 (10.4%)	9089 (9.2%)	6983 (8.1%)
every 4 years	17000 (12.0%)	11921 (10.4%)	9307 (9.3%)	7196 (8.2%)
every 5 years	17000 (12.0%)	12091 (10.5%)	9514 (9.4%)	7403 (8.3%)
every 6 years	17000 (12.0%)	12248 (10.5%)	9710 (9.5%)	7602 (8.5%)
every 7 years	17000 (12.0%)	12395 (10.6%)	9894 (9.6%)	7793 (8.6%)

15% pre-tax ROR

Tax Rate	0%	15%	25%	35%
every year	32919 (15.0%)	20087 (12.8%)	14371 (11.3%)	10236 (9.8%)
every 2 years	32919 (15.0%)	20638 (12.9%)	14970 (11.4%)	10770 (10.0%)
every 3 years	32919 (15.0%)	21151 (13.0%)	15545 (11.6%)	11297 (10.2%)
every 4 years	32919 (15.0%)	21628 (13.1%)	16094 (11.8%)	11812 (10.4%)
every 5 years	32919 (15.0%)	22070 (13.2%)	16615 (11.9%)	12313 (10.6%)
every 6 years	32919 (15.0%)	22478 (13.3%)	17107 (12.0%)	12797 (10.7%)
every 7 years	32919 (15.0%)	22854 (13.3%)	17570 (12.1%)	13261 (10.9%)

The results do make sense, although it was a bit surprising at first. I expected the effect of turnover to have a greater effect that the tables show. The greatest effect is at high return, high tax rate and high turnover; i.e., at 15% pre-tax ROR at 35% tax rate, the difference between high and low turnover is 10.9%-9.8%=1.1%. But, this leads me to think, hmmm, maybe I shouldn't worry about turnover so much, and focus more on reducing the tax rate by moving?

Anyway, the table is food for thought for now. I am sure I'll refer to it later.