The Advantages of Tax Managed Investing (Note: Corrected Tables)

Abstract

Recent advances in online portfolio trading have brought investors much closer to achieving the frictionless paradigm often assumed in portfolio theory. However, taxes remain a significant barrier. We show that even a passive equity fund, like the Vanguard 500, has a significant drag on taxes, causing an investor to be left with only 54 % of his pre-tax value after 24 years. We find that passive portfolio investors can reduce taxes substantially by selling losing stocks and replacing them with characteristically matched stocks. We begin by providing an analytic framework to quantify the effects of taxes on investment returns. The pre-tax returns are effected by two components; short-versus-long tax rates and foregone earnings. We isolate the two effects to give the reader a sense of the magnitude of these effects. Using the effective tax rate as a measure of the tax drag, we find that the theoretical cost of foregone earnings is as high as 30 % and that the theoretical costs of realizing short-term gains is as high as 31 %. We then investigate the tax management possibilities in the real world by considering different equity strategies to reduce the investor's effective tax rates. We apply these strategies to US equities from 1990- 2000 and find that it cuts taxes by as much as 4.8 %, significantly increasing the after-tax return.

Keywords: Taxes, Investing, Tax Harvesting, Synthetic Dividends

JEL Classification: G0