The Impact of Taxes
...The Foolish Four still comes out ahead

by Chris Rugaber (TMF

Alexandria, VA (April 8, 1999) -- As April 15th creeps closer, let's continue the tax discussion we've been having this week by revisiting one of the frequently asked questions about Foolish Four investing: what is the effect of taxes on our backtested returns? Given that the strategy requires trading every year, is it really that great when taxes are considered?

The short and most accurate answer is that everyone's tax situation is different and therefore there's no way to really give an estimate of the impact of taxes on the "average" investor. However, it's also worth pointing out that when general calculations of capital gains taxes are done, the Foolish Four still comes out ahead of the Standard & Poor's 500 Index in total return over the long run.

A longer answer is that tax considerations have their place in any investment approach, and how taxes impact the Foolish Four's returns is dependent on several different variables that all investors should keep in mind when setting up their portfolios. Let's look at a few of these variables.

Obviously, the first consideration is whether your Foolish Four holdings are in a tax-advantaged account, such as a traditional IRA or Roth IRA. If they are, then you don't have to worry about paying taxes on your Foolish Four trades. Nevertheless, keep in mind that if you are in a traditional IRA, you will have to pay taxes when you withdraw the funds, and those taxes will be at regular income tax rates, not the lower capital gains rates. Of course with a Roth, there are no taxes of either kind. For more information on IRAs, please see our recent series of articles on the subject in our
Money area.

If you're not in an IRA of some kind, the second factor to consider is how often you sell your stocks. As all Fools know, you don't pay capital gains taxes until you sell, and with the Foolish Four you will sell, at most, four stocks per year. If you usually trade more frequently than that, then the Foolish Four may provide some much-needed discipline in your investing life. But what if you're a true long-term investor, with solid discipline, and just want to let your money sit in a S&P 500 index fund? Well, technically, your tax bill will be lower, but so will your after-tax returns. How is that possible?

Let's consider the example included in our Foolish Four guide. If a Foolish Four investor begins with $2,000 and adds $2,000 every year for 25 years, with an average annual return of 18.72% (I'm using the Foolish 4.1's ultra long-term return from 1963-1997 to be conservative), she will have $527,359.42 after annual capital gains taxes are taken out each year. Another investor who places the same amount in an S&P 500 index fund returning 13.06% per year (the S&P's average annual return over the same 35-year period) will have $344,330.12 after annual capital gains taxes. So the Foolish Four is already way ahead. But that's not the end of the story.

Over the years, the Foolish Four investor has paid $95,071.88 in taxes, while the S&P 500 investor paid only $5,240.19, assuming 1% turnover per year (the composition of the S&P 500 changes regularly, generating small capital gains). Yet a final capital gains tax of $67,417.99 will be due when the S&P 500 fund is sold, reducing the index fund investor's portfolio to only $276,912.13 after all taxes are paid, even further behind the Foolish Four investor.

In addition to these calculations in our Foolish Four guide, former Fool Robert Sheard also made some general tax calculations in an article last year. He uses slightly different numbers but arrives at a similar conclusion: the Foolish Four still outperforms the S&P 500, even after taxes. Of course, all these numbers are general; for actual tax advice, please visit our tax area.

Finally, a third consideration is that the dividends the Foolish Four companies pay are taxable as well, but at the higher, regular income tax rate. This may create a slightly larger tax burden for Foolish Four investors than for others. The S&P companies generally pay lower dividends as a group than the Foolish Four, which after all were selected for their high dividend yield. For simplicity, our example above assumed that dividends were taxed at 20%. They would normally be taxed at a higher rate, but because dividends constitute a fairly small percentage of the total returns, the difference is not enough to change the above numbers very much.

So while we may not like the IRS, even the impact of annual capital gains taxes doesn't make the Foolish Four less of an attractive investment. Perhaps that can cheer us all up as we consider our tax bills. Fool on!

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Today's Stock Lists | 1999 Dow Returns

04/08/99 Close
Stock  Change   Last
CAT  +   1/8   48.63
JPM  +2  9/16  130.00
MMM  +   3/8   71.69
IP   -   1/8   43.94
                   Day   Month    Year   History
         FOOL-4   +0.66%   4.21%   7.17%   8.76%
        DJIA     +1.11%   4.21%  11.46%  11.01%
        S&P 500  +1.29%   4.48%   9.65%   9.92%
        NASDAQ   +1.14%   4.53%  17.36%  18.97%

    Rec'd   #  Security     In At       Now    Change

 12/24/98    9 JP Morgan    105.51    130.00    23.21%
 12/24/98   24 Caterpillar   43.08     48.63    12.87%
 12/24/98   22 Int'l Paper   43.55     43.94     0.89%
 12/24/98   14 3M            73.57     71.69    -2.56%

    Rec'd   #  Security     In At     Value    Change

 12/24/98    9 JP Morgan    949.62   1170.00   $220.38
 12/24/98   24 Caterpillar 1034.00   1167.00   $133.00
 12/24/98   22 Int'l Paper  958.12    966.63     $8.51
 12/24/98   14 3M          1030.00   1003.63   -$26.38

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4350.55