Do you know how much return clients invested in taxable accounts lose to taxes each year? While many investors scrutinize their portfolio's pre-tax return and net expense ratio, taxable investors should balance that data against the after-tax return. Remember, it's not what you earn, but what you keep that counts! Tax headwinds have the potential to get in the way of investors achieving their long-term financial goals.
To get a sense for these potential tax headwinds, we analyzed the average annual impact of taxes over the last 10 years ending January 31, 2014 on the Morningstar U.S. equity investment products data, which includes both actively-managed U.S. equity investment products and passively-managed (i.e., index and exchange-traded) U.S. equity investment products across market cap sizes and styles. We used a 10-year time frame in order to reduce the impact of the 2008 downturn, which has made many U.S. equity investment products appear tax-efficient in the past five years when, in reality, they were simply working off capital losses they accumulated in 2008.
Take 1: Tax drag on the average active and passive U.S. equity investment products
(Tax Drag = Pre-Tax Return Less After-Tax Return)
For the 10 years ending January 2014, the average fund in the universe we analyzed surrendered 1.02% of its return to taxes each year and had a net expense ratio of 1.05%
This means that the impact on total return of taxes and the expense ratio are nearly equal in this universe – even though many investors give the tax impact less attention.
Digging deeper into the tax impact, you find that the compounding effect of the 1.02% average annual tax drag represents a 10.7% return degradation over 10 years. That's not a small number! Add to that the fact that tax rates recently increased for many taxpayers, likely making the annual tax drag look worse going forward.
Take 2: Tax drag on the average U.S. equity large cap and small cap investment products
Next, we sliced the same Morningstar data by cap size (large cap and small cap) to see whether the tax drag and after-tax return dynamics differed for investment products depending on the cap size of the securities they invest in.
Within large cap, the median annualized tax-drag over the last 10 years was 0.86% and within small cap, the annualized tax drag was 1.15%.
