A study from Tweedy Browne titled “Investing For Higher After-Tax Returns: Lessons for Tax-Paying Investors from Warren Buffett, Index Funds, the Best Performing Stocks over an 18-year Period, and Our Own Experience” contains a section that highlights how delaying taxes as long as possible may dramatically increase the investor’s wealth at any given pre-tax rate of return.
This example is taken from the 1993 Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) annual report and depicts starkly how the net wealth of an investor is affected by (a) active buying/selling of investments, and payment of tax thereon, compared to (b) just sitting on the investment for an extended period of time, and paying tax just once.
Here’s the math over a 27.5-year period for the two cases:
(a) Investment $1, doubled annually and then sold, tax paid 35% each time, and net proceeds reinvested: Net wealth after 27.5 years =$1,000,000.
(b) Investment $1, doubled annually in a single investment that was sold only at the end of 27.5 years, tax paid once: Net wealth after 27.5 years =~$130,000,000!
Moral: “Tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.””
Tweedy Browne’s study
Tweedy Browne studied two equity return scenarios – 15% and 20% per annum, over variable periods from 1 year to 20 years, with turnover percentages varying from 0 to 100%. Tax rate assumed is 27%.
Here are the results:
One can see how in each return scenario, the net wealth at the end of 20 years falls dramatically with increasing turnover.
“As turnover increases, realized taxable gains increase, which means that an individual’s taxes increase, and therefore the amount of money that is invested and working on behalf of the tax-paying investor in the form of deferred taxes declines. For any given rate of pre-tax return, the end result of a higher turnover ratio is lower after-tax returns, which means less wealth at the end of any given period of time.”
In effect the investor allowed the taxes he paid to work for the government, rather than for himself. He therefore relinquished the compounding gains on those monies.