Gil’s Musings

Avoiding Taxable Investment Activity

That opening title is a quoted greeting often used by Max Herzstein, one of my favorite clients who died in 2011. Max’s hyperbole seems remarkably apropos for today’s musing topic: avoiding taxable investment activity.

In a recent “musings” I wrote about the value of long term tax deferral derived from infrequent trading. (read article here) The analysis showed that going 30 years without trading could add over two percentage points to a 9% annual compounded return. That analysis also assumed that all the securities held for 30 years were eventually sold and taxes paid. Even after tax, that longer hold period amounts to another $18,000 of value for each $10,000 invested. I was careful to not oversell the concept with unrealistic or punitive other activities that could make the calculation even more profound, but are nonetheless possible. So I avoided using short term gains or step ups in cost basis due to a death. But some people have pointed out that these other factors may be more likely than many believe, and these factors could be so profound that I was asked to do the calculations in the opposite fashion: choose the most punitive calculation possible, not the least punitive.

Remember that long term gains (held over 12 months) are capped at a 23.8% tax rate and short term gains are taxed like ordinary income. That could produce a tax rate as high as 43.4%. Remember also that holding an investment that increases in value is not taxed until you sell it, and selling it causes taxes to then be due on the profits. Remember also that current capital gains rules erase the taxable gains for any survivor. So capital gains tax gets wiped out when an owner dies, no matter who inherits the property, even a surviving spouse. Clearly this advantage is lost with frequent trading that resets the cost with each successive purchase and causes taxes to be due in each year a profit is recorded. The numbers get even more profound with higher trading costs or management fees, as well as contingency fees like hedge fund charging a 2% management fee and 20% of profits.

Remember also that the mutual fund marketing pitch you read or hear will almost never show after tax return. Clearly that would tarnish the pitch, but in fairness, everybody’s tax rate is different. What I wanted to do was contrast how profound a taxable gain must be when compared to doing nothing.

In the end I was trying to solve for this question: How much less of an annual return could I experience with better tax treatment and still have the same amount of money when compared to a frequent trading strategy with better investment results but worse taxation?

Segment Wealth Management Return  Bar Chart

So you can see from the chart above that the dollar values are the same over thirty years when a low turnover and tax efficient portfolio returns 7.98% annually and the short term trading strategy return is 15.2%. Now if the trading strategy is a hedge fund with a 2% management fee and 20% profit sharing, the gross return would have to be nearly 25% annually to keep pace with a “lowly” tax efficient strategy returning just 7.98%.

So the next time you think about the sexy aggressive investment that you are being shown with its flashy track record, remember that it likely must provide a huge return advantage to account for tax impact. Even more so if it has high fees.


Gil Baumgarten

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