The Taxman: Gotta Pay Uncle Sam

Tax season is upon us, and Uncle Sam is getting ready to collect. Nobody likes to pay taxes and nobody wants to pay more than they need to. Understanding how taxes affect your investments are vital to becoming a successful investor. Yes, they are a cost, but unfortunately we don't get to choose our rates. Like inflation, Tax rates are not in our control, but by understanding how they affect us we can adjust how we invest accordingly.

When it comes to factoring taxes into our investment strategy, index funds are more tax-effecient than mutual funds. Why is this so? If you've been reading the blog thus far, you know that index funds are passively managed funds and mutual funds are actively managed funds (since mutual fund managers are promising their investors of beating the returns of the market). This active management style not only increases costs of operating the fund, it also drives fees accrued from taxes that, like with any other product or service, get passed onto the customer.

According to Jack Bogle's Book, "The Little Book of Common Sense Investing," (TLBOCSI) the turnover rate of the average mutual fund, including both purchases and sales, is 78%/year (2016). Decades ago, in the 40's, 50's and 60's the average turnover rate was about 16%. This increase in turnover is due to the new culture of trying to beat the market, which causes hyperactivity amongst the fund managers. The huge increase in turnover rates have driven up costs, which is already a bad situation for investors, but higher turnover rates also increase taxes, which makes a bad situation worse.

The average index fund has a much lower turnover rate due it its passive investment strategy. According to the same book as stated above, the average turnover rate for an index fund is 3%, which makes the transaction costs passed onto the investor extremely low, almost zero.

Data and numbers always help drive a point home, so lets bring'em down. If you remember from a previous blog post (The Penalties of Being an Emotional Investor), I broke down the costs of being an emotional investor and how emotions can adversely affect our returns in the long-run. Let's use the same example, except this time we'll factor in taxes.

Recall that the average annual return, over the 25 year period (1991-2016), was 7.8% and the average annual rate of return for the S&P 500 Index Fund was 9.0%. Due to the higher portfolio turnover rate, the mutual fund investors were subjected to a 1.2% federal tax every year, therefore, the after-tax return of the mutual investor was cut down to 6.6% ( This is not including state and local taxes, which would further lower the returns). The Index fund investor, comparatively, were subjected to a lower federal tax, despite having higher returns. A large proportion of their taxes was on the higher dividend income earned by index fund investors (Remember: Mutual funds, because of their fees, eat up most of your dividend income--recall blog post: Mutual Funds: The Great Liars).

Now I need to break this down a little more in order to drive the point home and so that we really understand what's going on. When a mutual fund actively trades its assets in the market, sometimes what will happen is that they will buy low and sell high, which is great, because that means they're making money. This capital gain (profits realized from selling assets) has to get taxed at the capital gains tax rate. Now, because Mutual funds are actively buying and selling, they have a higher probability of having more situations of capital gains, which then have to be taxed. In other words, they have more "taxable incidences" happening. These "taxable incidences" accrue, you guessed it, taxes, which then get passed on to the investors.

Index funds, on the other hand, are not actively managed, which means they have less "taxable incidences," which in turn means lower taxes for their customers to pay on capital gains. The only time that an index fund investor would have to pay a capital gains tax is when they choose to cash out. Furthermore Index funds, due to their low costs, dish out higher dividends, which gets taxed like income.

The Federal Government recognizes dividends as income so they tax it at your income bracket, which sucks, but when we look at the statistics, index fund investors still come out ahead when comparing after-tax returns: "In mid-2017...Federal Taxes cost taxable investors in index funds about 0.45% per year, only about one-third of the 1.5% annual tax burden borne by investors in actively managed funds" (pg 88, TLBOCSI).

When it's all said and done, when we account for taxes between the index fund investor and the mutual fund investors this is what we have: "The average actively managed equity fund earned an annual after-tax return of 6.6%, compared to 8.6 percent for the index fund investor. Compounded, an 1991 investment of $10,000 generated a profit of $39,700 after taxes for the active funds, less than 60% of the $68,300 of accumulated growth in the index fund. The active lag: A loss to their investors of $28,600" (89, TLBOCSI).

Remember, we also have to include the other fees of investing like expense ratios, adverse fund selection, poor timing, and inflation. I know, the fees ravage our profits, which is why it's important to be extremely mindful of them. We don't have control over inflation and taxation, but the others we do. Index funds seem like the way to go in order to accomplish higher returns, lower fees, and tax-effeciency. It's not my personal belief, it's just humble arithmetic.

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