Monthly Commentary

June 2024 - Not All Returns Are Created Equal: Taxes, Time and After-Tax Returns

Dear Investors and Friends,

The impact of taxes on portfolio performance is an important but not exclusive consideration when making investment decisions.  Unfortunately, like so much else that we see when clients bring us their current portfolios for analysis, their existing advisors have often either ignored taxes completely or, conversely, become so focused on taxes that they made suboptimal investment decisions purely in the name of reducing taxes. Not surprisingly, the best approach is more nuanced than either extreme and, like so much else, we believe the importance of taxes as a variable in decision making is fundamentally a question of time and time horizon.  The purpose of this month’s letter is to provide a simple example to help provide some structure for how to think about taxes and your portfolio.

Isolating the Impact of Tax Rate on After-Tax Returns

From a tax perspective, investment income and long-term capital gains are distinct categories with different taxation rules. The highest marginal tax rate for income and capital gains is 40.8% and 23.8%, respectively, including 3.8% for Medicare in both.  Income taxes are paid annually, and long-term capital gains can either be short term or long term and paid when the gain is realized.

Accounting for the impact of taxes on a portfolio performance can get very complex very quickly.  So, to keep our discussion from straying too far from the big picture, we are going to consider one relatively simple example that assumes an investor starts with $1,000, receives an annual pre-tax return of 8% for 30-years and pays taxes in 1 of 3 different ways:

  • As normal income. An example of this would be a bond investor.
  • As capital gains each year. An example of this would be an investor that buys stocks and sells them after a year and buys a new set of equities.
  • As capital gains where taxes are deferred for 30-years and then realized. An example of this would be a buy and hold investor that buys an S&P 500 ETF and does not sell it for 30 years.

The chart below shows the impact of each tax-regime on profit over a 30-year period.

While the investor in each tax-regime receives the same pre-tax return of 8%, as the last two lines in the numerical summary below indicate, the impact of the tax-regime cannot be understated.

Key Take Aways

  1. Implications for Fixed Income Portfolios: The impact of tax-regime in the short term is relatively modest.  This is one of the many reasons we believe tax considerations are less critical in evaluating short duration fixed income portfolios.  Put another way, fixed income investing is fundamentally defensive in nature; return is typically lower on the scale of importance than capital preservation and liquidity.  Seen in this light, maximizing after-tax return should not be ignored, particularly when comparing fixed income investments to each other, but tax efficiency is not the primary objective.

  2. Implications for Long Term Equity Portfolios: While an annual after-tax return difference of 1.34%, the difference between taxes paid as normal income and taxes paid as capital gains each year, may not seem like much, it adds up meaningfully over time because of the power of compounding. After 30 years, the capital gains investor that pays taxes each year has earned a profit 63% greater than the income investor—$4,902 vs. $3,008.  Clearly when capital preservation and liquidity are not the main objectives, one should endeavor to position themselves in the lower capital gains tax regime.
  1. Pairing Long Time Horizons and Tax Deferral: The ideal long-term strategy is to defer taxes into the distant future.  In this case, the profit of a deferred tax strategy is 1.41 times greater than the strategy that pays taxes each year ($6,906 compared to $4,902). In other words, the deferred tax strategy generates an after-tax IRR of 7.14% compared to 6.10% for the strategy that pays taxes each year.  If one can position themselves to do so, the benefits of tax-deferral are enormous over the long term.

RCM’s Approach

While the above analysis is deeply compelling, it would be a mistake to conclude that one should exclusively invest in financial instruments that are likely to be taxed at capital gains rates and allow for the deferral of taxes. Different financial instruments have different risk and reward characteristics, and it is critical that one match their assets with the financial instrument(s) that are most likely to achieve their goals.

Sound asset allocation and financial planning segments assets into different buckets by objective. Broadly speaking, each entity or individual should have an “offense” bucket and a “defense” bucket. The offense bucket comprises assets that have a meaningful probability of achieving higher after-tax returns over the long term but will likely experience greater risk (i.e., drawdown and volatility) in the short term. The defense bucket comprises assets that have a meaningful probability of experiencing lower risk at the cost of achieving lower after-tax returns. The mix between offense and defense is a function of one’s particular circumstances.

Please don't hesitate to reach out with any questions or comments. Thank you for entrusting RCM with your capital; it's a privilege to serve you.

Warm Regards,

David and Mike

Learn More - Strategy Blog CTA


Roosevelt Capital Management LLC is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and are not guaranteed.  Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.

Past performance is not indicative of future performance.  Principal value and investment return will fluctuate.  No guarantees or assurances that the target returns will be achieved, or objectives will be met are implied.  Future returns may differ significantly from past returns due to many different factors.  Investments involve risk and the possibility of loss of principal.

While all the values used in this report were obtained from sources believed to be reliable, all calculations that underly numbers shown in this report believed to be accurate, and all assumptions made in this report believed to be reasonable, Roosevelt Capital Management LLC neither represents nor warrants the values, calculations or assumptions and encourages each prospective investor to conduct their own review of the audits, values, calculations and assumptions.