The value of tax-aware investing | Capital Group

  • About Our Firm
  • What Sets Us Apart
  • Wealth Planning
  • Latest Perspectives
  • Contact Us

The Value of Tax-Aware Investing

When it comes to investing, few variables impact overall results more than taxes. That’s because Uncle Sam takes his share directly off the top of any dividends and realized capital gains. Once you factor in the impact of state and local taxes, up to half of your investment return can quickly disappear without proper tax management.

Equity investors face three types of potential tax liabilities: short-term capital gains (on investments held less than one year), long-term capital gains (on those owned for more than one year) and dividends. The distinctions are important because short-term capital gains are taxed at an investor’s ordinary income rate, which can be as high as 35%. Long-term capital gains, along with qualified dividends, are currently taxed at a top federal rate of 15%.

As a result, managing your portfolio with an eye toward minimizing tax liabilities is essential. Of course, if your money is in a tax-deferred account, such as an IRA or a 401(k), this is not an issue. But for taxable accounts, which often represent the majority of assets for high-net-worth investors, it’s a critical variable.

The chart on above illustrates how taxes can significantly erode your portfolio over time. From 1926 to the end of 2008, the Standard & Poor’s 500 Index generated an average annualized return of 9.6%. Adjusting for federal taxes and an assumed rate of turnover, that number fell to 7.5% over the 82-year period. This may not sound like much, but take a look at what it means in dollar terms: before taxes, $1 would have turned into $2,049, demonstrating the power of compounding. After taxes, however, you’re left with just $403. This example does not include the burden of state levies, which would have driven the ending amount down even further.

The chart on the above illustrates how taxes can significantly erode your portfolio over time. From 1926 to the end of 2008, the Standard & Poor’s 500 Index generated an average annualized return of 9.6%. Adjusting for federal taxes and an assumed rate of turnover, that number fell to 7.5% over the 82-year period. This may not sound like much, but take a look at what it means in dollar terms: before taxes, $1 would have turned into $2,049, demonstrating the power of compounding. After taxes, however, you’re left with just $403. This example does not include the burden of state levies, which would have driven the ending amount down even further.

Capturing and keeping results

When evaluating an investment manager, absolute returns are very important. But you should also measure the manager’s after-tax “capture ratio.” This represents the percentage of a portfolio’s overall return that you actually keep after accounting for taxes. It’s a critical number because the higher the capture ratio, the more capital that remains in your portfolio to compound over time. The graph below dramatically illustrates this. It shows that a $1 million investment with a 10% pre-tax annual return grows to $10.8 million over 25 years. But with a 65% capture ratio, the portfolio only grows to about half that amount, or just $4.8 million.

1. Results reflect the reinvestment of dividends and exclude fees. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $100,000 in 2005 dollars every year. This annual income is adjusted using the Ibbotson Associates Stocks, Bonds, Bills, and Inflation® U.S. Inflation Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years. A shorter holding period would have resulted in an even lower after-tax return. No state income taxes are included.

The views expressed herein are those of the author and do not necessarily reflect the views of everyone at Capital Group Private Client Services. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, are subject to change at any time and should not be construed as advice. There is no guarantee that any projection, forecast or opinion will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with an Investment Counselor.