Taxes And Compounding

Taxes and compounding.

To shelter your savings from taxation while building your nest egg is extremely important. I believe this is pretty obvious for most investors, but I suspect it’s still neglected because the headwind takes about ten years to really make a difference.

Unless you have a tax-sheltered account you will take a beating whenever you receive a dividend or sell a profitable position. Most countries offer some form of tax-sheltered accounts and you should use them to your full benefit.

The graph below illustrates a 50 000 account compounding at 9% for 40 years:

The effects of taxes in a compounding account.

The blue line is 9% compounded for 40 years without taxes, while the pink line subtracts 25% taxes on unrealized gains every year. By delaying taxes you more than double your wealth. Quite a difference!

Obviously the tax-scenario is a bit unrealistic because unrealized capital gains are not taxed, so let’s change the circumstances a bit:

Let’s assume you own shares in Microsoft worth 25 000 with a cost price of only 5 000. You have turned bearish on Microsoft and would like to switch to Berkshire shares, but unfortunately the shares are in a taxable account.  You estimate Microsoft can only compound at 8% over the next decade, while Berkshire’s can compound at 12%. A switch to Microsoft needs to take into consideration the effect of the tax rate of 30%. If you sell Microsoft, you will only have 19 000 to reinvest because of 6 000 in taxes (20 000 x 30%). If your future estimated returns are correct, the alternatives are like this:

Value today Value in 10 years CAGR
Microsoft 25 000 54 000 8%
Berkshire 19 000 59 000 12%

This means you are better off switching to Berkshire instead of Microsoft. The alternatives are equal if Microsoft compounds at 9%. In other words, the tax equals a 3% annual “penalty”over a ten-year period.

Taxable dividends face the same challenge. The graph below shows 1 000 shares in VNQ purchased in early 2005 (56 750 USD) and held until September 2019:

Dividend reinvestment in VNQ. Tax rate is 20%.

The blue line is reinvested dividends without taxes while the pink line is the same dividend less 20% taxes. A no-tax scenario compounds the value to 182 000 USD, while only 159 000 subtracted 20% taxes. The difference in CAGR is 8.07% versus 7.12%.

You face some serious headwind if you keep your stocks in a taxable account, and the drag compounds over long time-horizons. A 1% annual difference amounts to much less spending in your retirement.

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