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Taxes can take a big bite out of your total returns. Of course, if you're saving for retirement and you qualify, that's a good reason to use tax-advantaged accounts like IRAs or employee retirement plans. But you can also minimize by taxes -- and increase your after-tax returns -- by increasing your average holding period.
Long-term investing saves on taxes
Holding investments for the long haul is a good idea for many reasons, including the tax benefits. Here's what Charlie Munger, vice chairman of Berkshire Hathaway, had to say on the subject in a 1994 speech at the USC Marshall School of business:
Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. ... If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.
To illustrate, consider the following three scenarios. In each case, you start an account with $10,000 and manage to earn annualized pre-tax returns of 15% with a series of investments.
- You hold your investments for six months. When you sell, you pay capital-gains taxes at your marginal income-tax rate -- say, 35%.
- You hold your investments for just over a year. This allows you to pay a long-term capital-gains rate of 15% (assuming you qualify for that rate), but you pay capital-gains taxes every year, given that you're selling every year.
- You hold your investments for 10 years. You pay the long-term capital-gains rate of 15%, but you only pay taxes once -- after you sell at the end of 10 years. You effectively defer your tax bill for a decade.
Note what a huge difference your investing style can make over the course of 10 years:
| Scenario No. 1 | Scenario No. 2 | Scenario No. 3 | |
|---|---|---|---|
| Starting Value | $10,000 | $10,000 | $10,000 |
| Pre-Tax Annualized Returns | 15% | 15% | 15% |
| Average Holding Period | 6 months | Just over 1 year | 10 years |
| Tax Rate | 35% | 15% | 15% |
| Ending Value (after 10 years) | $25,080 | $33,202 | $35,887 |
| After-Tax Annual Returns | 9.6% | 12.8% | 13.6% |
The less often you trade, the less you pay in taxes -- and the better your after-tax returns. The effect can be pretty dramatic. The difference between scenario No. 1 and scenario No. 3 is 4% in extra returns and more than $10,000 of extra money in your pocket. And that's only a 10-year period; over longer time frames, the effect compounds, and the benefit becomes even larger.
Don't let the tax tail wag the investment dog
Of course, if you can find investments to hold for the long term, it will save on taxes. But, at the same time, we don't recommend letting tax strategy drive your investment decisions. Taxes should be a consideration, but not the primary one. In that same 1994 speech, here's what Munger said:
But in terms of business mistakes that I've seen over a long lifetime, I would say that trying to minimize taxes too much is one of the great standard causes of really dumb mistakes. I see terrible mistakes from people being overly motivated by tax considerations.
Warren and I personally don't drill oil wells. We pay our taxes. And we've done pretty well, so far. Anytime somebody offers you a tax shelter from here on in life, my advice would be don't buy it.
In other words, don't be short-sighted when it comes to taxes. But don't forget about them, either!
The Foolish bottom line
If you're investing in a taxable account, look for the highest-return investments that you can hold for as long as possible. If you hold for more than a year, you'll probably pay capital gains at a lower rate, and if you hold for many years, you've essentially received a free loan from the government by deferring your tax bill. Saving on taxes is one of many reasons we like to hold our investments for three to five years -- or even longer -- here at The Motley Fool.
