Taxes and Your Investment Portfolio: The 40-Year Effect

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)