Investing for After-Tax Returns
As investors we should be more concerned with after-tax returns than pre-tax returns in that the money we have at our disposal net of fees and taxes is what matters most. Being agnostic to how investments are taxed in different accounts can cost investors dearly. Practicing smart asset location techniques, taking advantage of tax advantaged accounts where possible, and limiting portfolio turnover with tax efficient underlying investments in taxable accounts can all improve financial outcomes substantially. While we cannot control the markets and the returns received, we do have control over which accounts we utilize and how we manage our investments which can help optimize outcomes.
To help illustrate the importance of investing for after-tax returns, I’ve put together an overly simplified example below highlighting how after-tax returns can vary substantially in different account types and management styles despite having identical pre-tax returns:
After-tax wealth for various account types assuming at the end of 30 years all assets are sold and accounts liquidated.
Example Assumptions:
Initial portfolio value: $100,000
Expected average annual return: 8%
Time Horizon (years): 30
Assumed flat tax rate for all income types: 25%
*In reality the tax rates applied are much more complicated than this example as dividends, interest, short-term capital gains, long-term capitals, etc. can all have different rates applied to them depending on an investor’s personal tax situation and tax residency among other variables.
Scenario 1: Taxable account taxed annually
Future Value = $100,000[1 + 0.08(1 - 0.25)]^30 = $574,349
This scenario is similar to a regular taxable brokerage account with 100% turnover every year during the 30-year period. In other words, the account positions are 100% different than they were a year ago and 100% of the positions are being sold out of each year. This is an extreme case of what very “active management” can do to portfolio after-tax returns. Instead of an 8% return, in reality the portfolio is earning a net return of 6% each year after taxes.
Scenario 2: Taxable account with deferred capital gains ($100k cost basis)
Future Value = $100,000[(1 + 0.08)^30(1 - 0.25) + 0.25] = $779,699
This scenario is similar to a regular taxable brokerage account with 0% annual turnover during the 30-year period with just the account liquidation at the end. In other words, the investments are left alone to grow with no tax impact until the very end. This scenario also assumes the cost basis at the beginning of the 30-year period is $100k (the starting value). There is no lost compounding of return from paying taxes periodically and all tax is paid at the end of the time horizon. Limiting taxable events or “deferring” taxable gains has a massive positive effect on after-tax returns.
Scenario 3: Tax deferred account
Future Value = $100,000[(1 + 0.08)^30(1 - 0.25)] = $754,699
This scenario is similar to many common “pre-tax” retirement accounts such as US Traditional IRA and Traditional 401-k accounts where contributions to the account allow for a tax break on current taxation (contributions reduce current year taxable income), contributions invested grow tax deferred, and finally withdrawals are taxed as money is taken out of the account. As with Scenario 2, this example highlights the power of allowing returns to compound while deferring taxation.
Scenario 4: Tax exempt account
Future Value = $100,000[(1 + 0.08)^30] = $1,006,266
This scenario is similar to “after-tax” retirement accounts such as US Roth IRA and Roth 401-k accounts where contributions are made on an after-tax basis with no current tax break on contributions made. The contributions invested then grow tax-free going forward and are also tax-free upon withdrawal from the account.
Unsurprisingly, the tax-exempt account fares best in this simple example in that taxes put a drag on portfolio growth.
Determining which types of accounts to utilize is a very individual decision in that it depends on an investor’s current tax situation vs projected future tax situation, level of income (many tax advantaged accounts have income and contribution limits), country of residence (not all tax advantaged accounts have their status recognized in other countries), among other variables.
Now that we’ve established that after-tax returns vary by account and that asset location matters, it is important to understand high level asset location strategies.
The table below highlights how some common investment types are taxed in the US and generally where the best location for them would be in an aggregate portfolio.
Source: Fidelity
It should be noted that while important, asset location is only one piece of prudent portfolio management. Overall strategic asset allocation is the most important decision to be made in our view and that decision is very individual. It should be made based on a variety of factors including an investor’s overall financial situation, time horizon, risk requirement/tolerance, goal/return objectives, tax situation, liquidity needs, among others.
I hope these insights have helped solidify the importance investing for after-tax returns by taking advantage of tax advantaged accounts where possible, practicing smart asset location strategies, and investing in a tax efficient manner. We at Borges Financial offer comprehensive financial planning and investment management for a reasonable flat fee helping clients achieve their financial goals and optimize their financial situations.
Reach out to us for a complimentary introductory call if you would like to explore our services further.
