Taxes and Investment Returns

The amount you keep after taxes is what counts, as this article makes clear. It’s nice to make a good investment, but you have to manage the taxes as well as the investments. The article shows just how important taxes are to your returns. Failure to manage income taxes can reduce the life of your nest egg by a couple of years.

How would these taxes have impacted your returns?  Instead of compounding at 21.0%, the Altria investment would have compounded at 19.0%.  The final value of the investment would have been reduced by almost half, to $50.6MM.  With Berkshire, however, the final investment value wouldn’t have changed at all.  It would still be $77.0MM, because Berkshire didn’t pay any dividends.  Of course, you would still owe taxes on the $77.0MM, but you would be able to pay them on your own schedule, whenever you wanted to use the money.  And bear in mind that you would also have to pay taxes on the $50.6MM held in Altria.

We all recognize that taxes have a significant impact on long-term returns, especially when expected nominal returns are high.  But we normally assume that the impact is limited to cases of excessive short-term trading, where capital gains that could have otherwise been deferred are prematurely incurred at punitive short-term rates.  The truth, however, is that the detrimental impact of taxes extends beyond the space of capital gains, into the space of dividend income.  As the example illustrates, owning a portfolio heavy on dividend-paying stocks like Altria and light on cashflow recyclers like Berkshire can impose a substantial drag on returns over time.