How Taxes Can Destroy Investment Returns

For at least the last decade, the spotlight has been glaring down on investment management fees and the impact they can have on investment returns. Unquestionably, investors need to be aware of investment management fees and expenses when formulating their long-term investment strategy. But, in terms of the damage they can do to investment performance, they are nothing more than shiny objects, distracting investors from the real wealth destroyer—taxes.

The impact of taxes on investment performance is so significant, I made it the subject of an entire chapter in my book, Taking Stock. Left unchecked, their impact can delay retirement or threaten lifetime income sufficiency. Here are three critical elements of investment taxation every investor must know.

The Holding Period is Everything

Most investors are aware of the difference between a long-term holding period (more than one year) and a short-term holding period (less than one year) and the tax implications of both. Securities held long-term are taxed at lower rates than securities held short-term. Long-term capital gains are taxed at the more favorable capital gains rate, ranging from 0% to 20%, depending on your adjusted gross income. Short-term capital gains are taxed at your ordinary income tax rate, which can approach 50% when combining federal and state taxes.

In effect, holding securities for the long term is a highly effective tax deferral strategy, better in some respects than the tax-deferral in an IRA or 401(k). That’s because, when you draw down from an IRA, your withdrawal is taxed as ordinary income, whereas when you sell securities for income, you are taxed at a 0%, 10%, or 20% tax rate, which leads us to the next essential element to understand.

The Hidden Taxes Inside an IRA or 401(k)

Many investors who invest inside their IRAs or 401(k)s ignore the impact of taxes because they assume their investments are accumulating tax-deferred. While that may be true, it doesn’t account for the taxes being paid by fund managers on gains throughout the year. To pay those taxes, fund managers dock the investment accounts of their shareholders.

If you’re in a passively managed account, that might not have a significant impact on your returns. However, many active fund managers turn their portfolios over up to 100% each year, passing both the returns and the taxes on those returns on to investors. Unfortunately, you won’t know the full impact of taxes on your returns because fund managers are not obligated to tell you (though they are required to report after-tax returns to the regulatory bodies).

How Taxes Can Destroy Your Legacy

For many investors, their ultimate goal is to pass on a legacy to their children. If your legacy is primarily contained inside an IRA, your heirs will pay ordinary income taxes, thereby reducing its value significantly. However, if your estate consists of common stocks held long-term, they will be passed on to your heirs on a stepped-up basis.

So, for a stock you might have purchased at $10 a share and passed on at $50 a share, the cost-basis for your heirs is $50—meaning no taxes owed on a 400% gain. Plus, if the stock price decreases while your heirs are holding it, they could book a loss on the sale, reducing their taxable income. That’s what makes common stock ownership one of the best ways to maximize your legacy for your heirs.

Investors can dramatically improve their investment performance by considering all their investment decisions from a tax perspective. Here are three critical strategies to follow for minimizing taxes and freeing your investments to compound more quickly.

Allocate Your Investment in the Proper Accounts

Generally, investments that are not tax-efficient, such as high-turnover mutual funds, should be held in tax-qualified retirement accounts. Tax-efficient investments, such as a low-turnover stock portfolio or passively managed index funds, should be invested in a taxable account because there’s no need for tax deferral.

Think Long-Term for Taxable Investments

At the very least, you want to avoid short-term capital gains. If you’re invested in securities that you expect to grow in value over time, just hold on to them. It’s one of the most tax-efficient ways to invest.

Harvest Your Losses

You can create even greater tax efficiency through regular tax-loss harvesting, where you sell underperforming securities and use the losses to offset any gains you may have realized. You can also use losses to offset up to $3,000 in ordinary income and, if your losses are more significant than that, you can carry them forward to offset capital gains next year.

To have any chance of building wealth, investors have to make smart decisions on allocating their capital. Today, it is much easier to identify investments with low fees and expenses. It’s more difficult to consider all the tax implications of investment decisions. A sound investment plan needs to consider the impact of both fees and taxes, but the quickest path to wealth creation is through a tax-efficient strategy.

To learn more about investing in common stocks, you can download my book, Taking Stock, here.

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