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Last time we looked at the four investment principles which we believe will increase your chances for investment success. We specifically focused on how the compounding effect of fees could erode away return over time. This week we are going to discuss taxes and their effect on a portfolio over time.

Many investors have heard the saying, “do not let the tax tail wag the dog.” While you do not want to use taxes as the primary factor in making investment decisions, they do need to be taken into consideration. This week, we are going to look at issues that are specific to a taxable account rather than the type of account you should save in, as the latter is more of a planning issue.

There are various types of taxes that could be levied on your taxable investments. In the graph above you will see a table of the Federal income with dividend and capital gains tax rates.

In addition to these, a 3.8% surtax applies to net investment income for taxpayers with adjusted gross income (AGI) over $200,000 (single filers) or $250,000 (married filing jointly).

The key is to not pay excessive tax on your investments. If you do, these taxes will eat into your return the same way excessive fees do. Excessive tax may be caused by:

  • Having too much turnover in your portfolio causing excessive short- and long-term gains
  • Holding taxable bonds when you are in a high tax bracket
  • Having stocks that don’t pay qualified dividends
  • Having a high dividend portfolio when you do not need income
  • Holding active mutual funds which produce capital gains distributions

If you are in a very low tax bracket (and thus in the 0% Capital Gains and Dividend tax rate) you shouldn’t be too worried about these. But as your marginal tax bracket creeps up, these will become bigger issues. In the higher tax brackets, it would be easy for taxes to take away as much as 1-2% of your return away. Let’s look at what a 1% reduction in return due to taxes would do to a portfolio.

Here we’ll assume a $500,000 portfolio that earns 6% per year and how earning 1% less would affect the outcome.

Years                           6% Return                         6% MINUS 1 % for Taxes

10                                 $909,698.37                      $823,504.75
20                                 $1,655,102.24                   $1,356,320.14
30                                 $3,011,287.61                   $2,233,872.16

You can see over 10 years a difference of almost $90,000. Over 30 years, this increases to a little over $750,000. If you had a portfolio that produced excessive taxes AND had high fees (as illustrated in my last post), you can imagine the combined effect over time.

Make sure you understand the taxes that your taxable investments could produce, the tax bracket that you are currently in, and what the two might mean. No one can control the return on their investments in any given year, but we do have some control over the taxes they may produce. Focus on what you can control.