Taxes are an important consideration when making investment decisions. However, they are not the only factor. Though some tax-based decisions make perfect sense, focusing too much on taxes can hold you back from long-term growth. As we’ve often said: “Don’t let the tax tail wag the investment dog.” That means you shouldn’t base all your decisions solely on the immediate tax effect they will have.
The basics of taxes and investments
Planning investment decisions around existing tax rates is relatively straight-forward. You can estimate your income and your capital gains for the year. This can impact whether you purchase tax-free municipal bonds which generally offer lower yields than taxable bonds. If you can estimate your tax rates and your income, you can determine whether the lower yielding tax-free bonds are a better purchase than the after-tax income of the higher yielding taxable bonds.
Likewise, the certainty of incurring capital gains taxes is a factor to consider when either selling assets to fund distributions or rebalancing your portfolio. Taxes are a certainty, whereas investment returns are not guaranteed, so investors work to be careful about incurring these known costs. That said, if your portfolio becomes too risky because you’ve avoided incurring taxes, the investment losses will be greater when they eventually do happen. So, there’s a tradeoff to be considered. At the end of the day, there are only three ways to avoid incurring the capital gains tax bill: you can donate the assets to charity, you can lose your gains through negative returns, or you can wait until you die and the gains are no longer a problem.
What about tax increases?
In recent weeks, there has been a lot of discussion about the possibility of higher taxes at the Federal level. Joe Biden campaigned on a platform of raising some taxes, and his administration has floated some options for raising taxes to increase federal revenues to fund some of their projects. At the moment, it doesn’t appear likely that many (or even any) of the proposals will be enacted, but it does raise the question of what the impact of higher taxes might be on investment returns.
According to a recent blog post by Fidelity Investments, taxes have been raised 13 times since 1950. The S&P 500 index of the largest American companies had positive returns in 11 of those years, and the average of returns was higher in the years taxes were raised than in other years during the same period. In fact, according to an analysis by BMO Capital Markets, “during the five prior corporate tax rate increases…, the S&P 500 index posted an average calendar year gain of 12.9% with positive price returns in each instance. This gain was well above the 4.6% average return registered during the nine annual periods when the tax rate was reduced and higher than 9% price return for all calendar years going back to 1945.”
Correlation is not causation, and I’m not trying to say that tax rate increases are good for the capital markets. But clearly there is more going on than just taxes. Investors look at a lot of factors when deciding how to value companies and their potential profits, and only one of those factors is the taxes that the company (or the investor) will pay. The economic situation and a given company’s growth prospects are much more powerful drivers of corporate profits and investment results.
Investors need to be aware of what may happen in the background as Congress tinkers with tax rates but should not let that single factor drive investment decisions. Changes in tax policy are often very complex and take a while to ripple through capital markets. And in the current political environment, it’s not even clear that such changes will be enacted in the first place.
Keeping taxes in perspective
Taxes are a cost that can drag down the returns you earn on your investments. However, trying too hard to avoid taxes can hurt your long-term growth even more. The most important considerations as you manage your investment portfolio are your future earnings potential, your future spending needs, the valuations and prospects of the investments you are considering, and the health of the economy overall.
At Blankinship & Foster, we help you figure out how these all come together for your portfolio. We work with you to develop an integrated tax and investment plan, so you can make the best investment decisions to grow your wealth over time.