Taxes & Investment Performance

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  • Comparison of Highest and Lowest Marginal Tax Rates Marginal income tax rates and the number of brackets have varied greatly over time. The United States income tax system, as we know it, was enacted in 1913. Early on, only very high income individuals had to pay income tax. The image compares the highest and lowest marginal rates from 1926 to 2009. The highest marginal rate exceeded 90% during both World War II and the Korean War, while the lowest marginal rate rarely exceeded 20%. Overall, tax rates over the past 20 years have been lower than they were historically, particularly for higher income individuals. Source: Pechman, Joseph A., Federal Tax Policy, fifth edition, The Brookings Institute, 1987; Standard Federal Tax Reports, CCH.
  • Ibbotson ® SBBI ® 1926–2009 An 84-year examination of past capital market returns provides historical insight into the performance characteristics of various asset classes. This graph illustrates the hypothetical growth of inflation and a $1 investment in four traditional asset classes over the time period January 1, 1926, through December 31, 2009. Large and small stocks have provided the highest returns and largest increase in wealth over the past 84 years. As illustrated in the image, fixed-income investments provided only a fraction of the growth provided by stocks. However, the higher returns achieved by stocks are associated with much greater risk, which can be identified by the volatility or fluctuation of the graph lines. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks, are subject to significant price fluctuations and business risks, and are thinly traded. About the data Small stocks in this example are represented by the fifth capitalization quintile of stocks on the NYSE for 1926–1981 and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S. Micro Cap Portfolio thereafter. Large stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Government bonds are represented by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. Underlying data is from the Stocks, Bonds, Bills, and Inflation ® (SBBI ® ) Yearbook , by Roger G. Ibbotson and Rex Sinquefield, updated annually. An investment cannot be made directly in an index.
  • Ibbotson ® SBBI ® After Taxes 1926–2009 Taxes can have a dramatic effect on an investment portfolio. Stocks are one of the few asset classes that have provided significant after-tax growth over time. This image illustrates the hypothetical growth of inflation and a $1 investment in stocks, municipal bonds, government bonds, and treasury bills after taxes over the time period January 1, 1926, through December 31, 2009. Over the long run, the adverse effect of taxes on investment returns becomes especially pronounced. Stocks are the only asset class depicted that provided any significant long-term growth. After considering taxes, government bonds barely outperformed inflation over this time period. Municipal bonds (for which income is exempt from federal income taxes) outperformed government bonds but significantly underperformed stocks. In a world with taxes, focusing on fixed-income assets alone has not provided investors with a substantial increase in wealth. If you desire substantial after-tax growth, you may want to consider a larger allocation to stocks. Another alternative, if you are able, is to consider tax-deferred investment vehicles. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and municipal bonds are not guaranteed. Stocks have been more volatile than the other asset classes. Municipal bonds may be subject to the alternative minimum tax (AMT) and state or local taxes, and federal taxes would apply to any capital gains distributions. About the data Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $100,000 in 2005 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No capital gains taxes on municipal bonds are assumed. No state income taxes are included. Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Municipal bonds are represented by 20-year prime issues from Salomon Brothers’ Analytical Record of Yields and Yield Spreads for 1926–1984 and Mergent’s Bond Record thereafter. Government bonds are represented by the 20-year U.S. government bond, inflation by the Consumer Price Index, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
  • Ibbotson ® SBBI ® After Taxes and Inflation 1926–2009 The adverse effects of inflation and taxes on investment returns become especially pronounced over the long run. This image illustrates the hypothetical growth of a $1 investment after considering the effects of both taxes and inflation on each asset class over the past 84 years. Of the asset classes considered, stocks are the only asset class that provided significant growth. Municipal bonds, for which income is exempt from federal income taxes, barely provided enough total return to offset inflation. Government bonds closely kept pace with inflation. Treasury bills, however, fared the worst. After considering both taxes and inflation, the initial $1 was reduced to approximately $0.54. If you wish to overcome the effects of taxes and inflation, you may want to consider a larger allocation to stocks. Another alternative, if you are able, is to consider tax-deferred investment vehicles. Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and municipal bonds are not guaranteed. Stocks have been more volatile than the other asset classes. Municipal bonds may be subject to the alternative minimum tax (AMT) and state or local taxes, and federal taxes would apply to any capital gains distributions. About the data Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $100,000 in 2005 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No capital gains taxes on municipal bonds are assumed. No state income taxes are included. Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Municipal bonds are represented by 20-year prime issues from Salomon Brothers’ Analytical Record of Yields and Yield Spreads for 1926–1984 and Mergent’s Bond Record thereafter. Government bonds are represented by the 20-year U.S. government bond, inflation by the Consumer Price Index, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
  • Taxes Significantly Reduce Returns Intuitively, you know that taxes reduce the earnings you retain. This image illustrates how much the federal government withheld from one hypothetical investor following a simple long-term investment strategy. Stocks after taxes assumes that the stocks purchased were held for five years, then sold, and the capital gains realized. The net proceeds from the sale were reinvested. Dividends were taxed when earned and reinvested. From 1926 to 2009, the average return on stocks after taxes was 7.7%, compared to 9.8% before taxes. Bonds were turned over 27 times within the 84-year period. Capital gains were realized at the time of sale and reinvested. Bonds averaged a 3.4% return after taxes, compared to 5.4% before taxes. After taxes, on average, bonds barely outpaced the inflation rate. Cash earned an average of 2.3% after taxes, compared to 3.7% before taxes, over this time period. Comparing the after-tax return to the rate of inflation, you can see that if you invested solely in cash equivalents, you actually lost money in terms of purchasing power. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. About the data Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $100,000 in 2005 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included. Stocks in this example are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Government bonds are represented by the 20-year U.S. government bond, cash by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for transaction costs.
  • Lower Capital Gains Taxes Have Benefited Stocks in Recent Years In recent years, capital gains tax rates have been significantly lower than most marginal tax rates. Currently, the capital gains rate is 15% for investors in the 25%, 28%, 33%, and 35% marginal tax brackets and 5% for those in the 10% and 15% brackets. This tax treatment has generally benefited stocks because the primary purpose for investment in them is capital appreciation. Income payments in the form of dividends are generally secondary and makes up a much smaller portion of a stock’s total return. Historically, dividends were taxed at marginal income tax rates, though since 2003 dividends on qualified investments have also received favorable tax treatment. Conversely, bonds are predominately an income-producing investment with low to moderate levels of capital appreciation. As such, the income received from coupon payments are taxed at an investor’s marginal income tax rate. Since marginal tax rates are higher than the capital gains rates, bond investments generally have been taxed more heavily than stocks over the time periods illustrated. While taxes are an important consideration in the investment process, it is important to keep in mind that returns and principal invested in stocks are not guaranteed and that stocks have been much more volatile than bonds historically. Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. About the data Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $100,000 in 2005 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included. Stocks are represented by the Standard & Poor’s 500 ® , which is an unmanaged group of securities and considered to be representative of the stock market in general. Bonds are represented by the 20-year U.S. government bond. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for transaction costs.
  • Benefits of Deferring Taxes While it is impossible for individuals to avoid taxes with most investments, it is often possible to defer taxes. Deferring taxes over long periods of time can result in substantial gains. When holding investments subject to taxation, it is possible to defer taxes by delaying the sale of the investment (not realizing the gain). However, taxes on income, such as coupons or dividends, must be paid annually. The impact of taxes on an investment portfolio can be significantly reduced through the use of tax-deferred investment vehicles. Examples include individual retirement accounts (IRAs), company-sponsored 401(k) plans, 403(b) plans, Keogh plans, and tax-deferred annuities. Talk to a professional investment advisor to learn more about the differences between these tax-deferred investment vehicles and to your employer to learn about plans sponsored by them. Tax-deferred plans work by allowing interest, dividends, and capital gains to accumulate without incurring taxes. Taxes are due only when the investment is sold (once withdrawals from the plan begin). This image illustrates how deferring taxes can increase the value of an investment over time. A hypothetical value of $10,000 is invested in both a taxable and a tax-deferred account. The difference is fairly modest after 20 years. After several more years, however, the difference is more substantial. Allowing the investment to grow tax-deferred for 30 years would have provided approximately $11,745 more than the taxable account. After 45 years, the difference is even more dramatic. Returns and principal invested in stocks are not guaranteed. Withdrawals of tax-deferred accumulations are subject to ordinary income taxes. A 10% federal tax penalty may apply to withdrawals made before age 59½. About the data This hypothetical example is for an investor in the 28% bracket using the 2009 tax code (estimated to become the 31% tax bracket in 2011). $10,000 is invested in stocks at the beginning of year 1 (2010). Assumes an 8% annual total return (6% price return and 2% income return) and a 15% tax rate on capital gains and dividends in year 1 (2010), after which the rates revert to 20% and the investor’s marginal tax rate, respectively. The investment is taxed at a 28% marginal tax rate in year 1 (2010), and then reverts to 31%. Taxes are assessed yearly on the taxable account but only at the end of the period on the tax-deferred account. Estimates are not guaranteed.

Transcript

  • 1. Taxes and Investment Performance
  • 2. Comparison of Highest and Lowest Marginal Tax Rates 1926–2009
    • © 2010 Morningstar. All Rights Reserved. 3/1/2010
    80 60 40 20 100% Marginal tax rate • Highest rate • Lowest rate 0 1926 1936 1946 1956 1966 1976 1986 1996 2006
  • 3. Ibbotson ® SBBI ® Stocks, Bonds, Bills, and Inflation 1926–2009
    • Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    0.10 1 10 100 1,000 $10,000 $12,231 $2,592 $84 $21 $12 Compound annual return • Small stocks 11.9 % • Large stocks • Government bonds • Treasury bills • Inflation 9.8 5.4 3.7 3.0 1926 1936 1946 1956 1966 1976 1986 1996 2006
  • 4. Ibbotson ® SBBI ® After Taxes 1926–2009
    • Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926, with taxes paid monthly. No capital gains taxes are assumed for municipal bonds. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Assumes reinvestment of income and no transaction costs. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    $1,000 100 10 1 0.10 $12.05 $6.51 $15.96 $36.22 $510.68 Compound annual return • Stocks 7.7 % • Municipal bonds • Government bonds • Treasury bills • Inflation 4.4 3.4 3.0 2.3 1926 1936 1946 1956 1966 1976 1986 1996 2006
  • 5. Ibbotson ® SBBI ® After Taxes and Inflation 1926–2009
    • Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926, with taxes paid monthly. No capital gains taxes are assumed for municipal bonds. Assumes reinvestment of income and no transaction costs. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    0.10 1 10 $100 $0.54 $1.33 $3.01 $42.39 Compound annual return • Stocks 4.6 % • Municipal bonds • Government bonds • Treasury bills 1.3 0.3 – 0.7 1926 1936 1946 1956 1966 1976 1986 1996 2006
  • 6. Taxes Significantly Reduce Returns 1926–2009
    • Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    7.7% 5.4% 3.4% 3.7% 3.0% 0 2 4 6 8 10% Stocks Stocks after taxes Bonds after taxes Bonds Cash Cash after taxes Inflation 9.8% 2.3%
  • 7. Lower Capital Gains Taxes Have Benefited Stocks in Recent Years Spread between before- and after-tax returns over various holding periods
    • Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    5-year 0 4 2 3 3-year 10-year 20-year 5% Return spread 1 0.3% 3.0% 0.7% 0.3% 0.3% 3.2% 3.5% 4.9% • Stocks • Bonds
  • 8. Benefits of Deferring Taxes
    • Hypothetical value of $10,000 invested in stocks. This example is for an investor in the 28% bracket using the 2009 tax code. Assumes an 8% annual total return. Estimates are not guaranteed. This is for illustrative purposes only and not indicative of any investment. © 2010 Morningstar. All Rights Reserved. 3/1/2010
    0 50 100 150 200 $250k 5 years 10 15 20 25 30 35 40 45 to retirement • Value of taxable account • Value of tax-deferred account