We’re often asked about the tax consequences that come hand-in-hand with active investing. Given the substantial tax impact of high portfolio turnover, it’s easy to understand these concerns.
Our wealth advisors think that the IRS must love financial advisors who pursue active investing because of the massive about of taxes which are routinely generated. Given the additional tax burden created by active investment models it is very hard to understand why so many investors willingly follow financial advisors who are committed to active stock picking.
Speaking of taxes and taxation, Caesar once said that “It is the duty of a good shepherd to shear his sheep, not skin them.” Unfortunately, active managers don’t follow this sage advice, leaving their advisees stuck holding the (tax) bill. Here are a few of the tax consequences of active investing.
Why Efficient Investment Guidance Doesn’t Include the Active Investing Approach
Investment tax efficiency correlates to capital gains distributions. Capital gains -- or losses, as the case may be – represent the net difference between an asset’s purchase price and its sales price. Capital gains tax applies only when the gain is realized, i.e. the asset is sold and converted to cash; “paper profits,” or gains that aren’t converted to cash, are exempt.
The not-due-until-realized aspect of capital gains tax applies to:
Mutual fund companies
Other tax-paying entities, such as corporations and trusts
The realized portion of capital gains is impacted by a portfolio’s turnover rate and that’s where the added tax burden associated with active management comes in. Not surprisingly, higher turnover, such as that found in an actively managed portfolio, means that stocks are being bought and sold more frequently. These sales trigger the realization -- and taxation -- of the gains.
When turnover rates reach 80% or higher (and actively managed mutual funds have an average rate of 85%) there’s very little opportunity for tax deferral. The average holding period has decreased from eight years in the 1960s, to 15 months in the mid-1990s, to a mere five days today, and even at 15 months, capital gains are deferred for just a bit longer than when annual taxes are paid.
Tax Benefits of Passive Wealth Management Strategies
In contrast, index funds have significantly lower annual turnover rates at 5 to 30%. A 5% rate corresponds to an average holding period of 20 years. In essence, tax deferral is the equivalent of an interest-free loan; even if you eventually pay the same amount of taxes, postponing payment provides a longer time period in which to control and use those funds.
But active funds’ short average holding period results in more pain than simply paying taxes sooner than later. When gains are realized on stocks held less than 12 months, expect to pay short-term capital gains taxes at the same rate as your normal income tax, generally from 10 to 39.6%, depending on your tax bracket.
Long-term capital gains, on the other hand, receive favorable treatment. Rates vary from 0 to 20%, depending on your total taxable income. That means that high-income taxpayers may pay up to 19.6% more taxes on short-term capital gains – a significant difference that could easily be avoided by adopting a different investment approach.