The Art and Science of Investing in the Presence of Taxes

Gregg Fisher for Forbes writes: Here we are in December, when one of the rites for many investors each year seems to be to suddenly awaken to possible year-end tax moves. Perhaps your accountant has rung to discuss which portfolio positions to sell for tax reasons. The financial press is replete with versions of “smart year-end tax strategy” articles. This is all well and good, but in this column I want to make the case that: a) investors should pay attention to tax strategies such as tax-loss harvesting during the entire calendar year, and b) investors should do a much better job of integrating their taxes and Form 1040 with their investment portfolio strategies.

I grew up immersed in taxes (my family had a tax-accounting business), and I have reviewed thousands of tax returns and also advised countless clients on investing for more than 20 years. One thing that continually strikes me is how people tend to compartmentalize their financial lives, separating their tax returns from their investment portfolios. In behavioral finance this disconnect is called mental accounting. Investors need to recognize that taxes and adroit tax management are key considerations when formulating and executing an investment strategy.

It’s What You Keep That Counts

One basic issue is that investors should focus more on their after-tax return; for taxable investors, how much an investment earns matters less than how much of that return they actually keep after taxes. You can think of it this way: unlike inflation, interest rates, market gyrations, or the returns of individual securities or active fund managers, the taxes you pay on investment gains are one aspect of investing over which you can exercise a considerable degree of control.

We can quantify the importance of adept tax management in investing. Research by Gerstein Fisher and others (for example, see Past Performance is Indicative of Future Beliefs) shows that investors typically surrender one to two percentage points of investment returns to taxes each year—which quickly adds up when compounded over a 30-year investment horizon. We believe that skillful, active tax management can add back 0.5-1 percentage points to after-tax portfolio returns each year (remember that the benefits are greater for taxpayers in higher tax brackets).

The exhibit below depicts one scenario. I calculated a popular US stock index fund’s pre-tax and after-tax returns from September 1, 1976 to December 31, 2013, using a 40% tax assumption for income and 25% for capital gains. Bear in mind that investing in index funds is one of the most tax-efficient strategies out there for stock investors. Even so, on a pre-tax basis, a $100,000 investment in the index fund compounded at 11.04% a year, multiplying to a $4.99 million terminal value, but only at 9.53% for an ending balance of $2.99 million on an after-tax basis. In sum, income taxes subtracted 1.5 points of investment gains per year and reduced gains by 40%, or $2 million. An investor can reduce those losses to taxes through skilled tax management at the portfolio level. [snip].  The article continues @ Forbes, click here to continue reading....