It’s all very well to search for the best-performing stocks, but if we aren’t careful about our management of those stocks, all that extra time and effort will not pay off. Taxes can be a quiet killer of above-average returns and are the subject of chapter nine of Jeremy Siegel’s book, “Stocks for the Long Run.”
Leading into the chapter, Siegel quoted legendary investor John Templeton: “For all long-term investors, there is only one objective—maximum total real return after taxes.”
Stocks, said Siegel, are well suited for this objective. Capital gains and dividends are treated favorably in the American tax code—fixed-income investments are not. This is yet another advantage for equities over bonds and Treasury bills, another compounding edge that helps make them better long-term investments.
Real before- and after-tax average rates of return, in the century since the U.S. federal income tax was established in 1913, looked like this:
Stocks:
- 6.1% for untaxed investors.
- 2.7% for investors in the highest tax bracket who triggered capital gains each year.
Taxable bonds:
- 2.2% for untaxed investors.
- -0.3% for investors in the highest tax bracket and who paid taxes on their returns.
Treasury bills:
- 0.4% for untaxed investors.
- -2.3% for taxed investors.
Municipal bonds, which were not taxed, earned a 1.3% annual real return over the course of the century.
Essentially, taxes do the greatest damage to fixed-income investments. While stocks are not immune to this effect, the after-tax returns for them were still higher than the untaxed returns of bonds and Treasuries.
Next on Siegel’s list of tax issues was the benefit of deferring capital gains taxes. In 2003, the U.S. tax code reduced the tax rate on qualified dividends and capital gains to 15%, bringing the two rates to the same level (the rate was later raised to 20%). However, the effective taxes on capital gains are still lower than those for dividends. This happens because taxes on capital gains are triggered only when the asset is sold, whereas the tax on dividends is triggered as the gain is accrued, quarter by quarter. Siegel called this difference the “deferral benefit” of capital gains.
This deferral benefit can be significant for long-term investors. Siegel used the example of two stocks: one yields 10% per year in dividend income and the other yields 10% in capital gains. Investors are taxed 20% on their dividends and capital gains, and hold the stocks for 30 years. The dividend yield will be 8%, while the capital gains yield will be 9.24%. As the author noted, that’s just 76 basis points less than untaxed income.
Therefore, from a tax perspective, companies have a reason to generate capital gains rather than dividend income. Siegel called that “unfortunate” because dividend-paying stocks generally produce better before- and after-tax returns than stocks that do not pay dividends. He added that governments could level this field by providing tax deferrals on reinvested dividends until the stock is sold.
Another important issue is inflation. No consideration for inflation is available when capital gains are calculated and taxed; investors pay tax on the difference between the nominal purchase and selling prices. Thus, investors who sell are being taxed not only on the gain, but also on the inflation that has occurred, and the purchasing power of the capital gain is diminished.
To some extent, companies can offset this inflationary hit by increasing their prices, but there is still an effect. Siegel offered the example of an investment with a five-year holding period and an average inflation rate of 3%; this will result in the investor losing 60 basis points per year (compared with an inflation rate of 0%). He called this effect an “inflation tax”.
This inflation tax can have a “devastating” effect when the holding period is short. The more often the investor buys and sells, the more often the government can tax the nominal capital gain. Siegel created this chart to show these effects:
The author added there were political initiatives to adjust for inflation in the U.S. tax system, but nothing had been passed by the time this edition was published in 2014. Pressure to reduce the inflation tax has been muted in recent years because of low inflation rates.
And, as of 2014, there had been several other tax law changes that worked in favor of investors who held stocks. Siegel calculated that changes over the preceding 30 years had increased real after-tax returns on stocks by roughly 2%. Taxable bonds also saw improved returns, but not by nearly as much as the improvement for stocks.
In the background of all discussions of taxes on investments lies the matter of tax-deferred accounts (TDAs). They include Keogh, IRA and 401(k) plans. Siegel argued that many considerations come into play when total investments exceed the tax-free limits of these plans. That can lead to decisions about which asset classes to include within tax-sheltered walls; for example, using a TDA for stocks or for bonds.
After reviewing different circumstances that might affect such decisions, Siegel concluded: “It is better for most investors to hold stocks in their taxable accounts, unless they are active traders.”
He followed up, in his conclusion, by noting the importance of tax planning. In general, though, stocks have a considerable advantage over taxable bonds and Treasury bills. That was especially true for the few decades before 2014 because capital gains and dividend taxes had been reduced, inflation had been tamed and companies had repurchased shares to increase their capital gains.
Taxation, then, is yet another reason to choose stocks for the long run.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
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