That Pesky Tax Hurdle
by MF DowManWhen the Investing for Growth Primer was first released nearly two months ago, several readers expressed concern about the shorter-term nature of the approach and what affects it would have on capital gains taxes. At the time, I wrote a Fribble suggesting that the tax differences generated by some of the short-term gains would not drag down the portfolio's returns enough to justify abandoning the approach. But as all Fools should be, the skeptics remained unconvinced. They didn't want theories, they didn't want DowMan's assurance. They wanted the numbers!!!
So, let's take another stab at the tax issue and set up as many unfair hurdles for Investing for Growth as possible to see how it stacks up against the longer-term Beating the Dow approach, with its more favorable capital gains tax treatment.
The highest ordinary income tax rate is currently 39.6%. And any short-term gains on stocks (positions held less than one year) would be subject to being taxed at the investor's ordinary income tax rate, not the more favorable maximum long-term rate of 28%.
Let's assume an investor who falls within this highest tax bracket. And let's also assume that all the capital gains are taxable; that is, there is nothing to offset any gains, making every dollar of profit taxable. And to raise the bar even higher, let's assume that every return on an Investing for Growth stock is a short-term gain and is therefore taxed at 39.6%. In reality, this is obviously not the case. Some of the biggest winners for Investing for Growth have been long-term holdings, but for the sake of this argument, we'll make the more stringent assumption. And one final assumption---in the two years when Investing for Growth lost money, these losses did not get carried over to offset future gains. They simply went as non-events for tax purposes.
A $50,000 Investing for Growth portfolio---taxed to the gills every year---would have grown to $558,957 from 1980 to the present (assuming the year ends at today's levels). That's a 16.3% after-tax return using the worst possible scenario for taxation. That still represents a market-beating return, even after taxes---a feat the majority of mutual funds can't match BEFORE taxes.
Now let's take the same taxpayer, the same $50,000, and use the best performing of all the various Beating the Dow portfolio strategies---the Foolishly Modified BTD4 (stocks number 2, 2, 3, 4, 5). Since this strategy only produces long-term capital gains, we'll use the maximum 28% tax rate. (Since our model taxpayer is in the 39.6% ordinary income tax bracket, she'd have to pay the maximum rate on long-term gains as well.)
The $50,000 Beating the Dow portfolio would grow to $493,673 in the same 16-year period, representing a 15.4% annual after-tax return---also a market-beating performance.
Granted, there's only a $65,000 difference between the two portfolios after 16 years, but I think it's time for a reality check for our model. First of all, we have no idea what's going to happen to taxes in the future. Will we get a capital gains tax cut? Will we get a flat tax? In addition, as I mentioned above, the scenario I laid out for Investing for Growth isn't accurate in the sense that some of the gains (some of them substantial ones) are NOT short-term gains, and would be taxed at the lower rate for long-term gains. So, even though slashing the returns with the highest possible tax rates does make the Investing for Growth portfolio returns look a little less gaudy, they still beat the market soundly and stay a few paces ahead of the best other mechanical approach known to Fools---Beating the Dow.
If we get some tax restructuring, the picture could even become more attractive. Of course, the ideal solution is to use Investing for Growth in a tax-deferred account and let the gaudy returns compound unabated.