Lower Taxes: Another Benefit of Long-Term Investing

Drawing on wisdom from Berkshire Hathaway vice chairman Charlie Munger, analyst Brendan Mathews illustrates the tax benefits of long-term investing.

May 4, 2014 at 11:00AM

The following article is exclusive content from The Motley Fool. While this is typically paid content, we are bringing it to you free because we think it is especially pertinent to your ability to invest wisely.


Source: Flickr user David Reber.

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.

  1. You hold your investments for six months. When you sell, you pay capital-gains taxes at your marginal income-tax rate -- say, 35%.
  2. 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.
  3. 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. 2Scenario 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.

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Brendan Mathews owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

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That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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