Taxes: the unsung component of real investment returns
This is a tale of 3 stooges. And of the complications that taxes can add to investing, particularily for those fortunate souls in the highest tax brackets. For this entire discussion we are going to assume the highest tax bracket. The implications of taxation varies with tax bracket, generally being lower in lower tax brackets.
Basically, if you ohld a stock for a year before selling it you pay capital gains tax, if you sell it before a year you pay income tax. Income tax can be pretty dramatically higher than capital gains (20% higher, in fact).
Imagine you buy a share of a stock, like ASH, for 6 bucks. And you sell it for 26 bucks 8 weeks later. You've made 20 bucks, right? Well, no. If you're paying the max level of income tax you've made only 12 bucks (assuming 35% federal and 5% state). so instead of 4.3x your money you've actually gone just 3x your money.
If ASH never moved from 26 for one year and you sold, paid capital gains, you'd net 16 bucks (15% federal + 5% state = 20% taxes) profit and get to keep 22 bucks instead of just 18. Assuming the stock never moved you'd gain an additional 22% just for sitting around for a year. Thats a pretty good return.
To break even for selling out at 26 prior to holding for a year, one of these scnearios would have to play out:
1. you'd have to make a 25% return on the $26 you sold for befor ethe next tax date. you sell for $26, make another $6.50, pay 40% taxes on that, leaves you with about the $4 you would have saved for waiting for capital gains.
2. you'd have to have the same stock sink to $20.80 or so, buy it back with the $26, sell it at $26 again. You'd get 1.25 shares for your $26 and sell them for 1.25x5.20 = 6.50 profit. Basically the stock you own has to drop 20% for you to break even.
3. even if you bought it again to hold it for a period of more than a year from the date of the new purchase, assumig you sold it at the same price at some future date, you need to buy WELL under the price you would have sold for. Because you have to produce money to pay the taxes on the profits you made BEFORE the year for cpaital gains period is up. So you can't, in this scenario put all of the $26 back in because you'll need $8 of it before the next capital gains period is up.
Varying tax rates can HUGELY affect returns and complicate your investment strategy.
Now for the tale of the 3 stooges. 3 guys in the office in which I work, myself being one of the 3, got into the stock market in December with the S&P in the low 900s.
Today one of us is up about 150%. Say he started with 23 bucks and has 58. But about 25 of those gained $$ were short term, largely from day trading BAC, so lets say he now owes $10 of taxes, which means he has actually about 48 bucks or about a 100% return.
I'm up from about 50 bucks (these are not the real dollar amounts of course) to about 89 bucks (down from more like 98 bucks last friday, ouch!). I have about 5 bucks of short term gains, so I'm actually up about 87 bucks or about 75%.
The other guy is up to about 55 bucks from about 35 bucks, for about a 50% gain. But he, interestingly, has a $5 tax LOSS, meaning he is has roughly 57 bucks or roughly a 65% gain.
So 150% is actually 100%, 80% is actually 75%, and 50% is actually 65%, all because of taxes.
The basic lesson here is that if you want to achieve an actually great return, a big part of that is considering taxes. If you're income tax rate is 15% you are REALLY in the drivers seat, because taking short term profits is no different than capital gains, meaning this is your dream market.
Some strategies for hedging in gains to wait for capital gains are in order, I'll discuss them in my next post.