I’ve been thinking lately about the role taxes play in calculating investment returns. It’s not a question that’s very relevant to most people, since for the vast majority of Americans investments are best made in accounts that offer tax-free compounding, whether that’s an IRA, 401(k), HSA, or 529 account.
But once you start to think about it, there are potentially interesting implications for determining the best investment strategy for long-term taxable investors.
Over long time horizons growth and value stocks offer near-identical pre-tax returns
This may be somewhat difficult to grasp if you have a prior commitment to “value” investing, but if you think about value and growth stocks “overperforming” and “underperforming” over different time horizons, it becomes more clear.
Take two funds that have been available since November, 1992: VIGRX, the Vanguard Growth Index Fund, and VIVAX, the Vanguard Value Index Fund.
- Between November 2, 1992, and August 31, 2000, VIGRX outperformed VIVAX handily, returning an average annualized return of 21.66%, compared to the Value Fund’s 16.42%.
- Between September 1, 2000, and May 31, 2007, VIVAX outperformed VIGRX, returning an average annualized return of 6.1%, compared to the Growth Fund’s negative 2.65% average annualized return.
- Between June 1, 2007, and February 28, 2009, VIGRX outperformed VIVAX, returning a mere negative 28.39% average annualized return compared to the Value Fund’s negative 37.14% average annualized return.
- And from March 1, 2009, to February 28, 2018, VIGRX outperformed VIVAX, returning an average annualized return of 18.37%, compared to the Value Fund’s 16.76%.
But between November 2, 1992, and February 28, 2018, their returns were virtually identical: 9.42% annualized in the case of VIGRX, and 8.85% annualized in the case of VIVAX. As a reference, the Vanguard 500 returned 9.23% annualized over the same period, falling smack dab in the middle, just as you’d expect.
This is meaningless to tax-advantaged investors
A tax-advantaged investor without any special investing insight should invest in a broad global portfolio of stocks and bonds, with the precise allocation between domestic and international stocks and bonds depending on their risk tolerance, time horizon, and other sources of retirement income, like Social Security or workplace pensions.
You can see in the four time periods I outlined above that if you knew what was going to happen in advance, even a tax-advantaged investor would want to invest in growth stocks in the first time period, value stocks in the second time period, hold cash for the third time period, and then growth stocks in the fourth time period. But if they have no special insight into what’s going to happen, then a tax-advantaged investor should just buy, hold, and very occasionally rebalance.
Taxable long-term investors should think about dividend-minimal funds
What differentiates the returns between the Vanguard Growth Fund and Value Fund I described above is not their total return over the past 26 years, which is nearly identical: it’s the form those returns took. The Growth Fund experienced more price appreciation and less dividend and capital gains reinvestment, while the Value Fund experienced more dividend and capital gains reinvestment and less price appreciation.
I was trying to think of a way to illustrate this involving all sorts of calculations, but realized the easiest way is also the simplest:
- Between November 2, 1992, and February 28, 2018, a $100,000 initial investment in the Vanguard Growth Fund experienced a price appreciation of $650,700 and distributed $97,483 in dividends and capital gains.
- Between November 2, 1992, and February 28, 2018, a $100,000 initial investment in the Vanguard Value Fund experienced a price appreciation of $315,000 and distributed $193,666 in dividends and capital gains.
Under the current US tax code, the price appreciation is completely tax free, while the dividends and capital gains are taxed at a maximum marginal federal income tax rate of 23.8%. If that rate were in effect for the entire investment period (it wasn’t) then a taxable Value Fund investor would have paid $22,891 more in federal income taxes over the 26-year period than the Growth Fund investor, almost twice the amount by which the Value Fund investment outperformed the Growth Fund investment. If those tax savings were invested and allowed to compound over time, the Growth Fund investor would have done even better.
Useless, but good, advice
As I mentioned above, the overwhelming majority of Americans hold the overwhelming majority of their investments in accounts that offer tax-free internal compounding, so this information is properly useful only to the tiny sliver of people who have both an investing time horizon of 25 years or more and substantial taxable investments.
This is obviously something of a contradiction: by the time you’ve reached the point in your career where you’re maxing out all your tax-advantaged savings vehicles and have funds left over for taxable investments, you’re usually too late in your career to have a 25-year investment horizon!
Meanwhile if you struck it rich early enough to both have large taxable savings and retire early, you’re paying a 0%, not 23.8%, marginal income tax rate on your qualified dividends.
But just because advice isn’t very useful doesn’t mean it’s not good: if you have a long enough investing time horizon to not mind the achingly long periods of underperformance, then it can make perfect sense to hold lower-dividend mutual funds in your taxable investment accounts.
One class of person who would have a longer investment horizon late in their career would be persons married to someone significantly younger, especially if the younger spouse would continue working after the older spouse retires.
El Ingeniero,
That’s a good point, you could also imagine a high-income person who wanted to hold money outside their tax-advantaged accounts in order to make an unrestricted gift (instead of e.g. a 529 contribution) to their offspring during their lifetime.
—Indy
Wouldn’t paying the capital gains on dividends make more sense than paying the appreciation (assuming very close returns) if one is in a 25% + bracket?
Jeremy,
There are three reasons why that wouldn’t be the case:
1) When selling appreciated shares in a taxable account you can use “specific identification” of shares to sell the least appreciated lots first, or even lots that have lost value in order to claim losses on your tax return.
2) Dividends are taxable annually during your high-income years, while appreciation is only taxable upon sale, so if you’re in a lower tax bracket later in life (e.g. during retirement) you can sell your appreciated shares and pay low or no taxes on the appreciation.
3) If your goal is to pass wealth to a younger generation then your share appreciation would be completely untaxed due to the stepped-up basis loophole, whereby your heirs are allowed to assign inherited assets a new taxable basis on the date the assets are transferred, permanently exempting those capital gains from taxation.
—Indy
What about when your tax bracket isn’t lower in retirement?
Jeremy,
Well that wouldn’t apply then.
—Indy
What’s the recommended strategy in the case your bracket is the same or higher?
Jeremy,
If you have a high income and extensive taxable investments, my recommendation would to consult with a fee-only financial planner about tax planning.
In general, don’t be so afraid of paying taxes that you’re afraid of making money. Obviously you could avoid taxes completely by holding your taxable accounts in cash, but you’d avoid taxes because you wouldn’t be earning any return on them. Having said that, there are municipal bonds which may allow you to avoid income tax on your interest (although they offer correspondingly lower interest rates). Residential real estate is often considered a highly-tax-efficient method of investing, since you can defer capital gains indefinitely. There are some tax advantages to investing in early-stage startup companies as well.
But like I say, if you’re a high-income, high-net-worth investor you need much more personalized financial advice than I can legally give you here.
—Indy
Thanks