Sounds like a trick question, doesn’t it? What if I told you that I’m talking about investment returns? So, how can a 6% return be greater than a 9% return?
I promise I’m not tricking you or talking about some obscure investment. I’m just talking about the tax implications of investing and how quickly gains can be eaten up. A key focus for our investment team and advisors is not just returns, but AFTER tax returns. Every time that you receive a dividend or coupon payment or sell an investment for a gain, you could potentially owe taxes. For an investor in the highest marginal tax bracket (currently 37%), there are certain scenarios in which a return that is third lower on a pre-tax basis can actually net you a higher after tax return.
Let’s go through a simple, hypothetical scenario that demonstrates how taxes could affect your investments. We’ll use an example of a $3,000,000 investment account (not an IRA or other tax-qualified account) that earns a hypothetical 9% this year through buying and selling different stocks or funds throughout the year, holding them for a few days, weeks, or months at a time. Come tax time you’ll have to add that shot-term gain, $270,000 ($3,000,000 x 9%), as income for tax purposes. Since these were short-term capital gains (i.e. they were earned on investments held less than one year) and we’re assuming your salary and other income is over $250,000, you would (in this hypothetical) have to pay 37% in marginal taxes and an additional 3.8% for the Medicare Surtax. That’ll take $110,160 out of the $270,000 gain ($270,000 x 40.8%). So, after taxes, the REAL percentage earned is just 5.328%, not the 9% it appeared was earned.
$3,000,000 starting value
+ $270,000 (9% gain) in short-term gains
- $110,160 in taxes (40.8% tax on $270,000 gain)
$3,159,840 or 5.328% after-tax return
This simple hypothetical brings home one of our core beliefs: advisors need to do more than just manage investments. Without looking at the whole picture, the return you think you’re getting could be cut almost in half. Remember, the AFTER tax return is what you actually earned and can spend. Make sure you’re working with an advisory team that focuses on your AFTER tax returns, because that’s what really matters.
Important Disclosure: It is important to keep in mind that this is a hypothetical example and is not representative of any specific situation. Your results and your specific tax bracket will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.