Personal Finance Essentials
Taxes and Your Investments
Active Traders Underperform the Market by 10% a Year
Mostly Because of Taxes
Every investment decision has a tax dimension. The account type you use, the investments you choose and when you decide to sell them can all affect how much of your return you actually keep.
Capital Gains Taxes
When you sell an investment for more than you paid for it, the profit is called a capital gain and it is subject to tax. If you hold the investment for one year or less, the profit is a short-term capital gain, taxed at your ordinary income rate – which can be as high as 38% at the federal level. If you hold it for more than one year, the profit is a long-term capital gain, taxed at lower rates (generally 20% or less).
Because long-term rates are significantly lower, there is a strong incentive to hold investments for at least a year before selling. Active traders who frequently buy and sell can lose a substantial portion of their profits to taxes. Research has found that active traders underperformed the market by 10% per year on average – not because they picked poor investments, but because frequent trading generated excessive costs and short-term tax bills that consumed their gains.
You can defer capital gains taxes for years or even decades by simply holding onto your investments. You don’t owe the tax until you sell.
Mutual Fund Taxes
Mutual fund investors often encounter a surprise: a capital gains tax bill even in years when their fund lost money. This happens because of how funds are structured. When you own shares of a mutual fund, the fund itself owns the underlying stocks or bonds. As the fund buys and sells those holdings, it generates capital gains. Even if you personally didn’t sell any fund shares, you may still owe taxes on gains the fund realized internally. The fund sends you an IRS Form 1099 at year-end reporting your share of those gains.
Here is an example. Suppose you bought shares of a fund six months ago at $10 per share. By year-end, the share price has dropped to $8 – so you have lost money. But the fund has been around for 10 years and has been selling long-held positions at a profit. You will still receive a Form 1099 reporting capital gains distributions, even though you personally lost money on your investment.
This is not entirely bad news. When you eventually sell your fund shares, the taxes owed at that time will be reduced, because you have already paid a portion along the way. Fund investors who have owned a fund for many years sometimes find that when they sell, they owe very little – or nothing at all – in additional taxes.
Index Fund Tax Risks
Index funds are often praised for tax efficiency. Because they trade infrequently, they generate fewer taxable events each year. In practice, however, this picture is incomplete. Index funds do experience portfolio turnover: the Vanguard 500 Index Fund – one of the most widely held S&P 500 index funds – carries a portfolio turnover rate of approximately 2%, compared to an average of 46% for funds in the Large Blend category
More importantly, by trading less frequently, index funds accumulate a growing internal capital gains liability. If large numbers of investors sell their index fund shares at the same time – as often happens when markets fall – the fund must sell holdings to raise cash. That can trigger a large capital gains distribution for everyone who remains invested, regardless of how long they have held it. Index fund holders who expect to avoid annual taxes may eventually face a substantial bill, particularly during a market downturn, when it is least convenient.
Taxable Versus Tax-Deferred Investments
One of the most important tax decisions you can make is choosing between taxable and tax-deferred accounts. In a taxable account, you pay taxes on dividends, interest and capital gains distributions each year. In a tax-deferred account – such as a 401(k), an IRA or an annuity – your money grows without being taxed until you withdraw it. The longer your money can grow without the annual drag of taxes, the more wealth you can accumulate.
Variable annuities illustrate this benefit well. An annuity and a mutual fund can invest in the same underlying securities, but they are taxed differently. In a mutual fund held in a taxable account, you pay taxes on capital gains and dividends every year. In an annuity, no annual tax is owed – taxes are deferred until withdrawal. Transfers between investments within an annuity are also tax-free, making it easier to rebalance without triggering a tax bill.
That said, annuities have drawbacks. Withdrawals prior to age 59½ are subject to taxes plus a 10% IRS penalty. When you do withdraw, profits are taxed at ordinary income rates rather than at the lower capital gains rates. And if you die while owning an annuity, your heirs owe income taxes on the accumulated gains – unlike most investments, which receive a step-up in basis at death and pass those gains to heirs tax-free.
Annuities make the most sense when you intend to leave the money invested for at least 15 years and will not need access before age 59½. Putting annuities inside an already tax-deferred retirement plan – such as a 403(b) – provides no additional tax benefit and typically adds cost without benefit.
Don’t Let Taxes Drive Your Investment Decisions
One of the most costly mistakes investors make is letting tax considerations override sound investment logic. An investor who refuses to sell a declining position because doing so would realize a loss, or who avoids rebalancing because it might trigger a gain, is allowing the tax tail to wag the investment dog.
The goal of investing is to build wealth, not to avoid taxes. Taxes are a consideration, but they should never be the primary driver of your investment strategy. Investors who obsess over taxes often let their portfolios drift far from their target allocations, ultimately taking on more risk than they intended. Similarly, declining to invest at all because taxes will be owed on the profits is a losing proposition: not investing at all is worse than paying taxes on the gains you earn.