Raise Your Expectations

For too long investors have not gotten the full story about their investment returns. What’s missing is one simple, understandable performance number: after-tax return.  It’s time for investors to expect and get this crucial figure: “Here’s your rate of return after taxes.” I expect much of the financial industry cringes at this idea.

Let’s say your portfolio starts the year at $1 million and finishes at $1.06 million (with no additional capital invested). What’s your rate of return?  Of course it’s 6 percent. Unless you pay taxes on dividends (you do) and on capital gains (you do). If you end up paying $15,000 in taxes on dividends and gains, your 6 percent return quickly becomes 4.5. The 6 percent is a mirage; you keep and can spend only 4.5 percent.

By ignoring this simple math, most money managers and mutual fund companies give an incomplete and exaggerated view of performance. We believe after-tax return is an essential number, we manage for it, and we welcome the opportunity to discuss it with every client.

Twenty years distribution-free

The first step we take to reduce the tax bite is using index ETFs. The largest, and oldest ETF, SPY (which tracks the S&P 500) turned 20 years old earlier this year.  Investors who owned SPY for the last 20 years would have compounded their money at 8.42%, a rate anyone could love.  That’s doubling your money every 8.5 years.

But wait, what about taxes?  The only taxes that buy-and-hold SPY investors had to pay each year were the state and federal taxes on dividends. With minimal turnover SPY has had NO capital gains distributions in 20 years, and therefore has triggered no capital gains taxes for investors. Factoring in taxes on dividends, the annual compound return is 8.04 percent.  That results in a “capture ratio” – the percentage of return left after taxes  – of 95.5 percent.

With this high capture rate, $1 million invested in 1993 would be worth $5.2 million today.

If the same portfolio had been managed in a way that generated lots of turnover (buy and sell transactions) and realized gains – which is typical for active managers – tax exposure would rise and the annual after-tax return would be far less. For instance, if half of the gains each year were distributed and taxable, the after-tax return would be only 6.09 percent. That’s a capture ratio of 73.5 percent, meaning 26.5 percent of the annual gain goes to the IRS. With this 50 percent tax exposure (the yellow line below), instead of growing to $5.2 million, the after-tax value is $3.5 million.

If all of the annual gain is taxable each year, the capture ratio falls to 54 percent and the ending balance reaches only 2.5 million. Talk about catch-and-release!

What’s your after-tax return? 

Has your money manager ever helped you calculate it? To do so, just reduce your return by any state and federal taxes paid on dividends and short- and long-term gains. What you keep is really the only number that matters. It should be front and center when you discuss your goals and results with your investment advisor.

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This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives. 

SPY is discussed for illustrative purposes only. It may or may not be held in client accounts. Not all ETFs are managed to the same tax-efficiency. Historical SPY performance is not an indicator of future performance or results.

Tax rates change over time, and vary for individuals of different income levels. Dividends and short and long term gains are taxed at different rates. In our tax exposure calculations, we used an average total tax rate of 33 percent on capital gains and 20 percent on dividends, which represents federal and state tax rates combined. Your tax rates may be different. Consult your tax professional for more details on tax rates and tax planning.