Tax and Investment Returns

Tax and Investment Returns

It is imperative that investors focus on after tax investment returns and not pre tax investment returns. 

We have put together a few scenarios to highlight the importance of tax when investing.  The below scenarios assumes:

• An individual investor
• Top marginal tax rate 46.5%
• A stock is purchased for $10 on the 1 July 2009
• Stock price value $20 as at 30 June 2010 and 1 July 2010

Scenario 1 - The investor sells the stock as at 30 June 2010. The capital gain and taxable gain are both $10.  The investor loses $4.65 in tax resulting with an after tax return of 53.5%.

Scenario 2 - The investor sells the stock on 1 July 2011.  The capital gain is $10 but the taxable capital gain is only $5 because the stock was held for longer than 12 months.  The investor loses $2.32 in tax resulting with an after tax return of 76.80%.

Add another year for scenario 1 to be equal to scenario 2 (assuming no reinvestment and interest in scenario 2), scenario 1 would have to return 19.74% in year 2 assuming the 12 months 50% discount rule.

Granted this example is simple but it is an attempt to prove how costly turnover can be.

What is ideal turnover?

There is a no ideal turnover as such.  This is because even good fund managers generally only get 60-65% of their stock selections right.  What is important however is they get the most from the ones they get right and limit the damage of the ones they don’t.  So turning over badly performing stocks or ones with minimal capital gains will have minimal effect on overall investment returns from a tax perspective.

Another investment return incentive to holding stocks for longer is the 45-day tax dividend credit restriction.

Other Factors include:

• Applicable tax rates. For example income earned from superannuation pension interests are exempt from tax.
• Other taxable capital gains (or losses) need to be considered.
• The expected share movement of the stock in question and the replacement stock.  For instance in the above example if the stock was sitting at the $10 gain after 6 months and the investor expected it to fall back to $12 in the next 6 months selling it at $20 would be the better option.

Selection of Fund Managers

We believe most fund managers have very little regard for after tax returns.  We select tax orientated fund managers.