The Dow Approach
The Dow Approach
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FOOL GLOBAL WIRE LEXINGTON, Kentucky (January 13) -- At this time of the year, the issue of taxes comes up often in our forum. So let's look at how taxes affect the Dow Dividend Approach over many years. Given the long-term capital gains tax limit of 28%, let's assume our portfolio turns over completely each year. (It doesn't, of course, but let's work from the conservative end so we don't gloss over a potential cost.) The long-term historical average for the Dow Dividend Approach (depending on which variation you use) is roughly 23%. By the time you take into account 28% taxes on the entire gain each year, you're left with an after-tax return of roughly 16.5%. Now a buy-and-hold approach is probably best suited to an index fund where costs are low, you don't lose to the overall market average because you're actually buying just that, and you're still beating the vast majority of all other mutual funds. Vanguard's industry-standard S&P 500 Index fund has a long-term annual return (past ten years) of just under 15%, so we'll round it up. Keep in mind, this is a pre-tax return. Let's take these averages out over a 25-year period for a comparison. After 25 years of compounding your S&P 500 Index fund at 15% a year, a $20,000 portfolio would be worth $658,379. Now pay Uncle Sam the 28% gains you've deferred for 25 years, and the grand total after taxes is $479,633. Your after-tax compound return is reduced to 13.55%. The same $20,000 in the Dow Approach, paying taxes each year as you go along, would be worth $910,287 after 25 years. So yes, you've paid the government a lot more in taxes and lost the advantage of deferring them to the end, but what really matters is your after-tax return at the end of the period. With the Dow approach, you have nearly twice as much money as with the deferred-taxes, buy-and-hold, index fund route. So as much as we might hate taxes, settling for an inferior return in order to avoid them is hurting you in the long run. Stay Foolish! |
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