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Taxes: the unsung component of real investment returns



May 16, 2009 – Comments (2)

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.

2 Comments – Post Your Own

#1) On May 16, 2009 at 2:01 AM, checklist34 (98.77) wrote:

So say you are in USG, which is currently on the short end of the construction downturn.  but its a good company (leader in its field) with big profit potential during "up" cycles in its cyclic market and a good chance of going at least 2 or 3 times higher than todays share price someday.

But today its not making money and its not likely to sustain a share price above $15 for a while.  And it hits 17 like last week.

you like $17 for now, and you think it might turn down, but you bought at an avg of $5 so you don't want to get hit with the tax slap. 

You can hedge yourself by simply buying a put and selling a call at the same strike price.  This will, literally, create a short position in USG without having to borrow shares or risk a margin call.  you don't risk a margin call because the call you sold is covered.

If USG goes to 30, you break even, if USG goes to 12 you break even. 

So say USG does go to 12 from there (it did), you can close out the optoins positions and pocket about $5, which can now buy you about 1/2 of a share of USG. 

You pay income taxes on the gains from the options of course, but you don't pay income taxes on the BIG gains from the original purchase price, and you come out ahead in the end.

I am going to apply this strategy to my personal portfolio, and I've made a list of prices / percentage of my holdings to hedge for each of my stocks.  For example, I think ASH has hit a trading range and won't break through the $30 barrier until some new material news comes out.  So when it clears $25 I could hedge a bit, when it clears $27.50 I could hedge a bit more.  etc.

If the stock goes up and you lsoe money on the hedge, that isn't all bad.  because you can use tha tloss to offset gains from dividends, trades, other hedges, and so forth.  So even if you lose on the hedge, you'll still gain your tax rate of the upward move.

And... i fyou sell a call thats in the money, you raise some cash that you may be able to do something with (if the call is in the money in this options-short transaction, you net a cash gain {but a corresponding debit on your account})

good luck

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#2) On May 16, 2009 at 2:25 AM, checklist34 (98.77) wrote:

Another hedging strategy for these situations, with more upside but less hedge on the downside, is to sell a covered call.

ASH hits 25, so you sell a covered call for June at $25.  With ASH at 25 this probably goes for about $2.50. 

If ASH goes to 22 bucks by June options day you only lose 50 cents, because you gained about $2.50 from selling the call. 

If ASH goes to 30 you don't lose as much as you'd think.  MOST OF THE TIME (but not always) options aren't excercised prematurely.  So say ASH is 30 on the Wednesday before June options day, you'll probably pay about $5.10 to buy the call back (calls that are deep in the money tend to sell for about current price - strike price). 

So you didn't get all the way to 30 here, but you did get to $27.50 (you sold the call for $2.50 and bought it back for $5, meaning you lost $2.50 on the hedge.  But your stock went up $5, so you're still ahead $2.50.

And you now have a tax loss, which is an ASSET.  You get back 20-40% of that loss.  So in essence, assuming a 40% tax bracket, you only lost $1.50 in this scenario. 

This is another strategy, a little more bullish, that can help you hedge against downturns in stocks you aren't ready to sell yet.

Live and learn... and for me it generally takes alot of living to learn, but in time I slowly come to grasp how to use the tools available to me as an investor. 

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