Return is defined in its simplest terms as the money made or lost on an investment. Most investors think of this as what is received after the subtraction of management fees and expenses, however this definition overlooks a much larger variable in returns -- taxes. In fact, it is not what is earned, but what is kept that is most critical in investing.
Increased income taxes for high-income earners and high net worth individuals have been a reality for the past several years, and the potential exists for increased rates in the future -- despite the recent reduction in the top marginal federal income tax rate to 37% from 39.6%.1 Taxpayers in the top federal bracket who are residents of certain states that levy high city or state income taxes (such as California or New York) could face a combined marginal income tax rate of over 50% on taxable investment income. As a result, the difference between pre-tax and post-tax returns for high net-worth investors can be particularly wide.
"Tax aware" investing is becoming increasingly important as some investment strategies are better suited to tax-deferred accounts than taxable accounts. For example, strategies that target capital appreciation with high portfolio turnover or generate a significant amount of investment income can create a meaningful amount of taxes and be less attractive than expected on an after-tax basis.
Impact of Taxes on Investment Returns
Returns from many investments are subject to either capital gains or ordinary income taxes, based on the type of asset, the amount of time that has elapsed between purchase and disposition, and the financial vehicle within which the investment is held.
When selecting among various investment options, consideration should be given to the impact of taxes on potential total investment returns. The following chart shows the impact of taxes on a hypothetical investment scenario.
Figure 1. Effect of Taxes on $1 million investment with an 8% return2 3
An investment with a higher rate of return combined with a higher portion of the investment’s returns that are classified as short-term gains or ordinary income are indicators of an investment that is creating substantial "tax drag" (i.e., lost investment returns to taxes).
A “tax drag” rate of 34% can cause nearly a 60% reduction in returns over a 30-year period, which is over $5 million in this example.
Tax Efficiency of Asset Classes
The chart below provides examples of asset classes and their tax efficiency.
Exhibit 2. Asset Classes Ranked by Tax Efficiency
Tax Efficiency of Investment Vehicles
Investors have a variety of financial vehicles available to them and each has its own tax and liquidity characteristics. Taxable investment accounts and partnerships are typically subject to income and capital gains taxes each year as a result of the activities of the respective structure. Many retirement savings vehicles such as traditional 401(k) and Individual Retirement Accounts (IRA) are tax-deferred. Other vehicles not specifically limited to retirement savings, such as life insurance or annuities, can be also tax-deferred when structured properly.
Investment strategies that are tax-inefficient and have a high expected rate of return are optimal for owning within tax-deferred accounts. Assets with more tax efficiency and lower expected rates of return, such as municipal bonds, are poor choices for tax-deferred accounts.
Investors with a desire to allocate assets to investment strategies with high return potential, but also ones that have a high degree of tax inefficiency, should consider discussing with a financial professional options for locating those assets in structures that offer the benefits of tax deferral.
Appendix: Tax Cost on Investment Returns
The following tables show the reduction in expected rates of return due to taxes based on assumed net investment return and the percentage of gains classified as short-term capital gains, ordinary income, or long-term capital gains.4
1 Many deductions for high-income earners were capped in the Tax Cuts and Jobs Act, such as home mortgage interest and state and local taxes resulting in higher expected taxes in 2018 for certain high-income earners.
2 Rate of return net of investment management fees and expenses; assumed taxation of returns is 60% as short-term capital gains/ordinary income taxed at 40.8% (37% federal income and 3.8% net investment income tax rates) and 40% as long-term capital gains taxed at 23.8% (20% long-term capital gains and 3.8% net investment income tax rates).
3 This is a hypothetical illustration to show the impact of taxes on investment returns and is not indicative of the performance of any particular investment.
4 Net investment return is net of management fees and expenses. Assumes short-term capital gains and ordinary income is taxed at 40.8% (37% federal income and 3.8% net investment income tax rates) and long-term capital gains are taxed at 23.8% (20% long-term capital gains and 3.8% net investment income tax rates).
This material is not intended to provide tax, legal, or accounting advice. This information should not be used by any taxpayer for the purpose of avoiding or circumventing IRS rules and regulations.