Have you ever stopped to consider the true impact of tax on your investment returns?

Not the impact in dollars, or even in percentages. I find that investors often have a hard time visualizing or internalizing metrics like that. 

Instead let’s consider HOW LONG it would take an investor to earn back what was lost to tax. How many years at a given rate of return would it take to get back to even?

Let’s assume we’re talking about capital gains and examine a 20% tax liability on the sale of an investment asset. That could be real estate or stocks or anything that has appreciated in value and might trigger a tax liability.

Let’s also assume reinvestment of the after-tax remainder at an annual compounding rate of 5%. Let’s ignore income or other taxes on the annual return. At that tax rate and with that rate of return on investment, it takes 4.5 years of TAX-FREE return just to break even! 

Let's do the math to demonstrate....

$1,000,000 – 20% tax = $800,000

After-tax $800,000 reinvested at 5% annual compounding return

Year 1: ($800,000) × 5% = $40,000

End of Year 1 Total: $800,000 + $40,000 = $840,000

Year 2: ($840,000) × 5% = $42,000

End of Year 2 Total: $800,000 + $40,000 + $42,000 = $882,000

Year 3: ($882,000) × 5% = $44,100

End of Year 3 Total: $800,000 + $40,000+ $42,000+ $44,100 = $926,100

Year 4: ($926,100) × 5% = $46,300

End of Year 4 Total: $800,000 + $40,000+ $42,000+ $44,100+ $46,300 = $972,400

Year 5: ($972,400) × 5% = $48,600

End of Year 5 Total: $800,000 + $40,000+ $42,000+ $44,100+ $46,300+ $48,600 = $1,020,100

It is only in Year 5 that the above investor has earned enough to make up for the original 20% tax liability and finally break even. And that doesn’t take into account the income taxes that would be owed each year, which would be likely to further erode the true return on investment.

To understand how this calculation changes based on a given rate of return and a given tax liability, refer to the helpful chart below.

Another way to understand the impact of tax on investment returns is to evaluate the OVERALL return necessary to break even. This too can be calculated for varying levels of tax.

Let’s do the math to demonstrate, using the same numbers as before. We have a $1,000,000 asset sale with a 20% tax liability, leaving us with $800,000 to invest.

To invest that $800,000 and get back to breakeven at $1,000,000, it would require a return of $200,000. A $200,000 return on an $800,000 investment is equivalent to a 25% return. That means that even though the tax liability was just 20%, a 25% return on the remaining money is needed to make up for the tax loss! 

Again, refer to the helpful chart below to see the difference based on tax liability:

Using the right strategies to defer, reduce, and/or eliminate tax liability can potentially have an outsized impact on your returns and the growth of your wealth over time. It is important to work with the right tax, legal, and financial advisors to make sure you are not missing out on key tax strategies!

Whether you are selling real estate, stock, businesses, or are simply a high-income earner worried about income tax, let our team at Fortitude Investment Group demonstrate the power of proper tax planning.

Contact us today to learn more. In the meantime, feel free to check out our valuable resources here. 

Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter.  Please contact us if you wish to have formal written advice on this matter.