“I made 10% on my stock picks last year.” 

I hear statements like this a lot.

And today I’m going to show you how 10% isn’t really 10% and how most people are missing out on hundreds of thousands of dollars of money in their pocket.

But with a little education, you don’t have to.

To get the most out of your investments you need to understand two types of taxation: Accrual and Capital Gains taxes.

Accrual 

Accrual taxation gets applied to dividends and interest that you earn in your account. It just means that you pay as you go.

How do these accrual taxes affect my returns?

Let’s look at an example:

Bob invests $1,000 for 20 years in a bond that earns a pre-tax return of 10% annually. Let’s assume all of the return is paid in the form of interest, which will be taxed at his marginal rate of 22%.

Let’s look to see what the actual after-tax account value ends up being and what the consequences of these types of taxes are.

If taxes weren’t a factor, the future value of Bob’s investment will be $6,728. The gain would have been $6,728 – $1,000 or $5,728.

However after taxes, the future value will be only $4,491. This is a gain after taxes of $4,491 – $1,000 = $3,491.

The gain lost to taxes is $5,728 – 3,491 = $2,237. This equates to a tax drag percentage of 39%!

Why is the tax drag percentage higher than the rate Bob is being taxed at? Shouldn’t it just be reduced by the 22%? Ah my friend, you would think so, but just as compounding works wonders for your investment account on the positive end, it silently steals away your hard earned money when compounding works against you. 

Taxes are one of those ways that compounding works against you. And you can see the dramatic result – an almost 40% tax drag!

These adverse effects only increase as time goes on. 

 

Capital Gains

But accrual taxes are not the only type of taxes you may pay as an investor. There are also capital gains taxes!

The tax is only applied to the gain in the value on an asset. The benefit of capital gains (if there is a benefit with taxes!) is that the timing of the tax can be controlled. You decide when you buy or sell.

Standard capital gains taxes are lower IF the investment is held for longer than 1 year. If you sell before one year is up, then you’ll pay short-term capital gains rates, which are the same as your marginal tax rates.

Let’s use Bob’s investment again for another example of how capital gains taxes work.

Bob invests his $1,000 for 20 years at a pre-tax return of 10% only this time his return is subject to capital gains of 15%. If Bob never sells his investment during the 20 years, he won’t pay the 15% tax on the gain until the very end.

Same as before, with no capital gains taxes, the future value of his investment is $6,728. After subtracting out his initial investment of $1,000, his gain is $5,728.

If Bob is subject to capital gains taxes, then his $5,728 gain will be taxed at 15% or $859.

Unlike accrual taxation, the tax drag and the tax rate are the same since all the taxes were paid at the very end. 

However, if you trade frequently or utilize a mutual fund or ETF that does, you could be incurring short-term capital gains. These would be taxed like accrual taxes (Remember in that example there was a tax drag of 40%!) So you have to be careful that you’re not incurring these costs unnecessarily. 

 

Blended Taxation

In reality, portfolios are subject to a blend of interest, dividends and capital gains. 

Let’s say Barbara is a high-income earner and had an account worth $100,000 at the start of the year and it became worth $110,000 at year-end. A nice 10% pre-tax return that her broker was happy to tell her about.

The portfolio return included $300 of interest taxed at 37%, $4,000 in dividends taxed at 20%, and $2,200 of realized gains taxed at 20% (long-term capital gains rate).

The interest portion of that return is 3% (300/10,000).

The dividend portion is 40% (4,000/10,000).

And the realized capital gain portion is 22% (2,200/10,000).

This must mean that there is an unrealized gain of $3,500 to get us to the full $10,000 gain.

This means the weighted average realized tax rate for the year is 13.51%. Math: [(3%)(37%) + (40%)(20%) + (22%)(20%)]

The real return after taxes is the pretax return minus the tax rate:

10% x (1 – 13.51%) = 8.65%

Meaning the true return of Barbara’s investment account after taxes is NOT the stated 10% return but actually the 8.65% once we’ve factored in her taxes.

And actually, the return is lower than this! Remember that $3,500 of unrealized gain Barbara has? Well, she’s going to have to pay taxes on that amount at some point in the future. 

And this is only one year! Imagine the investment gains you’re not receiving because of the taxes you’re paying year over year.

Ok, I did the math and after 20 years, taxes have taken over $145K from Barbara!

Keep in mind that the returns displayed by fund managers and investment advisors are gross of taxes. Investors bear the burden of writing the check to Uncle Sam. 

 

Tax Optimization

I’ve revealed how not properly managing taxes in your portfolio can cost you hundreds of thousands of dollars in taxes. 

You’ve seen how paying taxes each year at marginal rates compounds into a tax drag that exceeds what you thought before.

And you’ve seen how important it is to manage all the different elements of a portfolio’s return – so you keep more money in your pocket.

What can we do?

You should stuff as much money as you can into retirement accounts as the taxes will be deferred or tax-free. This way, your money can harness the power of compound interest to earn you a higher return.

If you’ve reached the contribution limits of your retirement accounts, then start utilizing a taxable account.

Take care of what type of investments you choose for those taxable accounts.

Active mutual funds and ETFs incur more capital gains relative to passive funds as the managers of those portfolios buy and sell throughout the year to beat their benchmarks. The process looks like this: more trading leads to more selling which leads to more capital gains being incurred, which leads to more taxes being paid by the investor, and less money in your pocket 

The saying is true: It’s not what you earn, it’s what you keep that matters.