For this post, we’re going to discuss Capital Gains (which occur when selling an asset that’s gone up in value). I know…a tax related topic…so exciting, right?
Specifically, we’ll discuss how we set budgets (not to go over) for capital gains taxes and how clients (in aggregate) pay about half the capital gains taxes as compared to the average U.S. mutual fund.
If you have a brokerage account such as individual, joint, or trust account you are often subject to annual taxes because of both income (such as dividends or interest) and capital gains (selling something that appreciated in value).
Note: Tax-deferred accounts (IRAs, 401ks, 457s, Charitable) do not usually pay tax on income or gains, rather they may owe tax based on annual withdrawals. Corporate accounts vary.
First, a quick story about taxes and investment returns.
Sometime around 2007-2009, I had the pleasure of hearing Paul Stecko, then the CEO of Packaging Corporation of America (Ticker: PKG) speak at a conference in New York. Now, these types of events usually involve a hundred or so people crammed into a hotel conference room, listening to company executives pitching their company to much less experienced analysts with jobs for large investment management companies (mutual funds, hedge funds, etc). Sure, there are some exceptions in the audience, but it’s mostly a transient, inexperienced group of people.
As Paul discussed his business and mentioned that the company sought to earn good returns on its investments – basic fodder for these types of things – someone fired back in a slightly combative and condescending tone: “Are those AFTER-TAX rates of return” (strong emphasis on AFTER-TAX)? That’s how I remember the question, at least. It stands out because I was one of the rare ones unafraid to sit at the front of the room, because….
What happened in the next second was memorable. Without hesitation, Paul immediately shifted into a stern stance, tried to focus his eyes intently at the unknown audience member that shouted the question and fired back “are there any other kind?” as if to imply “why bother me with this nonsense, you fool!”. It was reminiscent of Jack Nicholson, for sure.
Paul was right, of course. For investors, the reality is they only get to enjoy after-tax dollars. Based on his response, I should have run out and invested in his company. According to Factset and as of this writing, it has given investors over a 850% total return since the middle of 2008 versus 350% for the U.S. S&P 500. In retrospect, that’s not surprising to me, since companies that are that protective of investors are rare.
Story over. Back to our topic of tax efficiency and managing capital gains. Because Paul’s right – it’s “after-tax returns that count!” In that spirit, we’ve now started to set a gains “target” for you each January based on our strategy and your anticipated cash needs. This strategy component to the capital gains budget starts each year as an investment aspiration. However, we can’t keep it locked in because sometimes our investment team simply decides it’s better to sell an investment than to hold it. But it is a good start to each year.
Importantly, we’re also aware of specific annual tax planning or your unique situation – if one exists – and will override that base budget for you. Of course, this is even better than our default investment aspiration! But the point is we’re mindful of gains and taxes when possible.
After we set our initial budgets and as the year goes on, with each new cash request you have or investment we make, our investment team reviews your gains budget to try and reduce your taxes. There’s a yin and a yang to this—so we are trying to balance that out all year, and if we get to an annual gains amount that we think might be astray from your expectations, our goal is to reach out to you proactively.
While still early on with this formalized “gains budget” process, we feel good about how it’s going. It’s an example of one of many things we’re doing “behind the scenes” to produce better outcomes for you.
You might ask, how are we doing so far? How do we know it’s working? Well, a few years ago, we showed a chart similar to the one below. Then, we moved from Fidelity to Schwab, and getting the data to put this together became quite tedious, but in the first quarter of 2023, we were finally able to get it done.
Our reason for putting this together and writing about it was to demonstrate that:
- Most of the mutual fund industry (and perhaps the entire investment industry) doesn’t care much about capital gains and the associated taxes.
- Jacobson & Schmitt Advisors does care, and we believe that our tax cost has been lower and more efficient than funds. Here you see our version of the data that holds us accountable.
As we state in point #1 above – we believe that most of the mutual fund industry (and perhaps the entire investment industry) cares little about capital gains and the taxes they generate. Our proof comes from Investment Company Institute (ICI). According to their data, the average U.S. mutual fund produced a 1.5% average annual tax “drag” over the last eight years simply due to capital gains (the dashed red line in the chart above). That would mean a $1,000,000 mutual fund portfolio would average $15,000 of taxes due each year! That’s unsurprising for Adam and Rich, who have fund industry experience.
Since we started tracking our numbers in 2014, the JSA taxable stock portfolio has produced about a 0.7% tax cost (the green bars above) due to gains, which would be about $8,000 less per year in taxes (continuing the example above). As Paul Stecko said—It’s after-tax returns that matter!
We’ll leave you with one final piece of good news on withdrawing money and booking capital gains: capital gains remain very efficient ways to get at money for spending for two reasons. First, you get your original investment amount back, tax-free. Second, capital gains tax rates are lower than income tax rates, for most of us.
As a result, we’ve never seen a situation where paying capital gains tax works out worse than receiving paycheck income or withdrawing money from a pre-tax account (401k, IRA, Simple, SEP, 457, 403b, Deferred Comp Plan, etc.). That doesn’t mean such a scenario doesn’t exist (it could – after all, we’re not CPAs); it just means we haven’t seen it yet.
In short, when it comes to taxes, we try to be mindful of them in all that we do: planning, investing, and trading. We believe that doing so is valuable, and it shows. We hope that all our clients are able to appreciate this mindset, but more importantly, are able to feel good about our efforts and benefit from them!
Here are a few questions we’ve anticipated, which we’ll try to answer:
What assumptions did you make to get your data?
For the mutual fund industry, we got the data from the Investment Company Institute (ICI) http://ici.org (specifically the annual factbook – direct link here).
For JSA data, here’s what we did:
- Grouped taxable portfolios into buckets
- Contributors (under 5% net inflows per year)
- Withdrawers (more than 1% net outflows per year but not greater than 12%)
- Everyone else
- Gathered only data for equities and capitals gains
- We ignored the dividend tax cost, which is uninteresting for this study
- We also weren’t interested in fixed-income tax costs because the point of fixed income is to earn income
The chart above shows the average of the “Everyone Else” and the “Withdrawers” buckets – where neither too heavy of a contribution rate (which makes managing gains easier) or heavy withdrawers (makes managing gains harder).
To be fair, at the high end of the withdrawers bucket, say, above 10% but less than 12% we saw capital gains tax cost hit about 2% in 2023 (we did not have too many of these, but still think that’s instructive to demonstrate that withdrawing more will likely result in more gains).
What other factors play into the capital gains that I experience each year?
This is an important question because our initial “default” budget that we set for you (assuming you don’t have a unique budget that we would instead use) is only based on our strategy and your cash needs.
However, there are four major factors:
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- Cash withdrawals – if you regularly withdraw money, we need to sell things to make that cash available, and that often will create “realized gains,” which are taxable. If your draw rate (as a percentage) is high then your withdrawals…all things equal… will be taxed at a higher rate.
- Length of holding period – the longer you’ve been invested in the JSA stock portfolio, the larger your unrealized losses likely are (unrealized is the technical word for gains you haven’t yet realized/recognized/earned by selling, and selling triggers the gains tax). This may not always be the case, but, for example, our longest company holding has been in the JSA portfolio for 21 years, and the gains there are quite high.
- JSA investment decisions – If we decide to sell something, it’s usually because we no longer think the investment is worth holding. And selling is the action that can create capital gains. The most likely thing that could cause us to “instant-sell” a holding would be that something has happened in the world that makes a company less competitively advantaged within its industry. Of course, that would be just our opinion (based on our analysis). Other reasons could exist, too.
- Specific tax planning – this would simply be unique to you. Maybe you’re targeting a tax bracket, planning around Medicare premiums, or maybe there’s a specific opportunity. In these cases, we’ll target a specific dollar amount of gains for any given tax year.
- Allocation changes – say you start the year with 80% stocks, but because of something going on in your life, your portfolio gets reallocated to 50% stocks. Selling stocks in taxable accounts will book capital gains.
Right now, our “capital gains budget” process is built on #1 and #3 above, unless #4 overrides it. To be sure, a specific tax plan for you could be our best work. However, for us to come up with a specific, or custom, plan, we require really great information like a tax return, maybe pay stubs, and an understanding of what you own and owe. If a specific plan really matters to your overall household net worth, we love to pursue that for you.
Perhaps, in future years, we’ll add #2 to the equation. We just haven’t done that yet, mostly because we think it will result in budgets that are higher than we need them to be.
Hopefully this piece helps explain how we think about booking gains and the efforts we go through to try to be tax-efficient investors. The partners at JSA are alongside you, so it only makes sense that, once again, being aligned with you helps guide us to do our best possible job for you. It’s after-tax returns that matter!
