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Course 505
Long-Term Investing's Tax Advantage

Introduction

As we discuss in another session, taxes are one constraint to consider when building a portfolio. Taxes are also one quantifiable advantage of long-term investing. There has always been an advantage to holding stocks long term, but the tax law changes in 1997 made that edge even sharper. Long-term investors, defined as those who hold a stock longer than one year, now enjoy a capital-gains tax rate of 20%. Short-term traders have their gains taxed at 28%. That may not sound like much of a difference, but it is.

The Toll Taxes Can Take

Consider two investors, McEnroe and Borg, who each have $100,000 in a taxable account. McEnroe uses his $100,000 to buy several stocks. But he's skittish. He shuffles his portfolio every year. Let's say his stocks rise 10% annually, and at the end of each year, he sells his holdings and re-invests the proceeds in other stocks. Because of McEnroe's short investment horizon, he pays 28% capital-gains taxes on his winnings each year. McEnroe's after-tax return is: Pre-tax return x (100% - tax rate) 10% x  (100% - 28%) = 0.1 x  (1.00 - 0.28) = 0.072
0.072 = 7.2%  When he retires in 20 years, McEnroe will have accumulated: $100,000 x  (1 + 0.072) 20 = $401,694 Borg, on the other hand, is a patient, buy-and-hold investor. He invests his $100,000 in a few solid companies and never touches his portfolio for 20 years. Let's assume he also generates a 10% annual return (the same as McEnroe) and sells everything at the end of 20 years. Because Borg holds his stocks for longer than 12 months, he qualifies for the lower tax rate applied to long-term capital gains--20%. Borg ends up with: $100,000 x  (1 + 0.10) 20 x  (1 - 0.20)= $538,200 McEnroe's response? "You've got to be kidding!"

Can Good Trades Offset Taxes?

But what if McEnroe's frenetic trading earned him extra returns? Maybe he has a nose for trends and is able to stay one step ahead of the crowd. Well, if McEnroe earns 12% a year (versus just 10% for Borg) he'll accumulate $524,560 at the end of 20 years--still more than $13,000 shy of Borg's final value. McEnroe rants, "You're joking!" Even assuming zero commission costs, McEnroe's returns would have to beat Borg's by more than 2% each and every year before McEnroe could gain bragging rights. That feat is tough without a crystal ball. Even if you buy solid companies at good prices, it's next to impossible to predict what their short-term returns will be. There's just too much noise in stock prices. In addition, once you subtract the broker's commission, McEnroe will have to pay every time he sells or buys a stock, and he slips even further behind.

Long-Term Investing's Advantages

Note than Borg accumulated more money than McEnroe for two reasons. First is the lower capital-gains tax on long-term returns: 20% for Borg versus 28% for McEnroe. The second is the power of compounding. Even if both Borg and McEnroe were each taxed at 28%, Borg would still come out ahead: $484,380 versus $401,690. Why? Every time you split the pot with the government, you have less money left over on which to earn compound returns. And compounding--earning a return on past returns--makes Borg a richer man. Borg shares none of his winnings with the government for 20 years, so all of his winnings compound. McEnroe, in contrast, shares 28% of his winnings with the government each year, leaving him only 72% of his investment on which to earn compound returns. Over 20 years, that difference really adds up. Taxes aren't the only advantage of a buy-and-hold strategy. If you buy stocks with the intention of holding them for many years, chances are you will be much more careful about what you buy--and less prone to jump on the latest hot stock or sector. So even in a nontaxable (or tax-deferred) account like an IRA or a 401(k), a buy-and-hold approach makes sense. This strategy is especially smart if you're using a high-cost, full-service broker. By throwing taxes and commissions into the equation, a high-turnover strategy really puts an investor at a disadvantage.

Quiz 505
There is only one correct answer to each question.

1 How are taxes a quantifiable advantage of long-term investing?
a. Capital-gains tax is lower for long-term investors, defined as those holding a security for one year or more.
b. The longer you hold a security, the higher it will go up in price and the lower the tax rate.
c. The longer you hold a security, the higher the taxes you'll pay when you sell.
2 All else being equal, the higher the commissions, the greater the total return on the portfolio.
a. True.
b. False.
c. Impossible to tell.
3 Which best describes what compounding is?
a. Security returns will multiply over time no matter how much is paid in taxes or commissions.
b. Returns decrease over time.
c. The ability to earn a return on past returns.
4 Smart trading:
a. Always offsets the tax burden of short-term investing.
b. Can offset the tax burden of short-term trading.
c. Never offsets the tax burden of short-term trading.
5 Which answer is <em>not</em> an advantage of long-term investing over short-term investing?
a. The lower capital-gains rate.
b. Fewer broker commissions.
c. The guaranteed higher return.
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