Most advisors understand that taxes are an impediment to portfolio growth. Despite this, it’s likely that many are not fully aware of the degree of impact that taxes have on accumulating wealth. One reason for this may be the difficulty in quantifying the issue. In this post, we will tackle the problem by examining the impact of federal and state taxes on portfolio growth.

The Assumptions

To begin, we will compare two portfolios. Portfolio A is not subject to taxation and Portfolio B is taxed according to the assumptions listed below. Here is a list of all assumptions used in the analysis:

  • Federal tax rate: 35%
  • State tax rate: 6%
  • Combined federal & state tax rate: 38.9% (Fed % x [1- State %] + State %)
  • Capital gains tax rate: 15%
  • Annual contributions: $10,000
  • Contribution period: 30 years
  • Total time horizon: 40 years
  • Gross annual return: 8%
  • Percentage of gross return subject to ordinary income tax (in Portfolio B): 25%
  • Percentage of gross return subject to capital gains tax (in Portfolio B): 10%

Here is an overview of the annual tax calculation applied to Portfolio B:

A)     Portion of annual earnings subject to ordinary income tax times 38.9%; plus

B)      Portion of annual earnings subject to capital gains tax times 15%; equals

C)      Total tax due

To clarify, if we invested $10,000 at the beginning of year one, earning a gross return of 8%, each portfolio would be valued at $10,800 (before taxes). If 25% of the $800 gain was derived from interest income and 10% from capital gains (leaving 65% from capital appreciation), the tax calculation would be as follows:

A)     $800 x 25% = $200 x 38.9% = $77.80 (ordinary income tax); plus

B)      $800 x 10% = $80 x 15% = $12 (capital gains tax)

C)      Total tax = $89.80

Portfolio A would be worth $90 more than Portfolio B after one year. If the same assumptions were applicable each year, Portfolio A would obviously grow faster than Portfolio B. Due to compound interest, as the years progress the growth curve of each portfolio becomes increasingly exponential. This makes the taxation of interest, dividends and capital gains much more significant.

For example, the difference in the two portfolios after one year was only $89.80, or 0.83%. After 20 years, the value of Portfolio A exceeds that of Portfolio B by $50,239, or 7.50%.

After 40 years (30 years of annual contributions), the amount of portfolio value lost to taxation is a staggering $552,870 ($2,641,418 – $2,088,548). This represents a difference of 20.93%.

The following graph contains the cumulative contributions ($10,000 per year x 30 years = $300,000) and the after-tax growth of each portfolio. The portfolio’s value markers are at 10-year intervals.

Click to enlarge  

Taxes are an important issue in portfolio growth. This is even more critical after several years of investing, with larger portfolios, and with clients in a high-tax bracket.

As such, it may be advisable to utilize ETFs for the stock exposure (due to their preferential treatment on year-end capital gain distributions), use tax losses to offset gains, and select more tax-efficient funds. Although it may not be wise to place taxes at the front of the line – which is like the tail wagging the dog – it is an important factor to consider when constructing and managing a client’s portfolio. 

Until next time, thanks for reading and have a great week!