Don’t Let Taxes Alone Drive Your Investment Decisions

| July 3, 2021 | 0 Comments

Taxes are a factor that has to be considered when making investment decisions, but they are not the only factor. As we’ve often said: don’t let the tax tail wag the investment dog.

Planning investment decisions around existing tax rates is relatively straight forward. You can estimate your income and your capital gains for the year. This can impact whether you purchase tax-free municipal bonds, which generally offer lower yields than taxable bonds. If you can estimate your tax rates and your income, you can determine whether the lower yielding tax-free bonds are a better purchase than the after-tax income of the higher yielding taxable bonds.

Likewise, the certainty of incurring capital gains taxes is a factor to consider when either selling assets to fund distributions or rebalancing your portfolio. Taxes are a certainty, whereas investment returns are not guaranteed, so investors work to be careful about incurring these known costs. That said, if your portfolio becomes too risky because you’ve avoided incurring taxes, the investment losses will be greater when they eventually do happen. So there’s a tradeoff to be considered. At the end of the day, there are only three ways to avoid incurring the capital gains tax bill: you can donate the assets to charity, you can lose your gains through negative returns, or you can die and the gains are no longer a problem.  

In recent weeks, there has been a lot of discussion about the possibility of higher taxes at the Federal level. Joe Biden campaigned on a platform of raising some taxes, and his administration has floated some options for raising taxes to increase federal revenues to fund some of their projects. At the moment, it doesn’t appear likely than many (or even any) of the proposals will be enacted, but it does raise the question of what the impact of higher taxes might be on investment returns.

According to a recent blog post by Fidelity Investments, taxes have been raised 13 times since 1950.  The S&P 500 index of the largest American companies had positive returns in 11 of those years, and the average of returns was higher in the years taxes were raised than in other years during the same period. In fact, according to an analysis by BMO Capital Markets, “during the five prior corporate tax rate increases…, the S&P 500 index posted an average calendar year gain of 12.9 percent with positive price returns in each instance. This gain was well above the 4.6 percent average return registered during the nine annual periods when the tax rate was reduced and also higher than 9 percent price return for all calendar years going back to 1945.”

Correlation is not causation, and I’m not trying to say that tax rate increases are good for the capital markets. But clearly there is more going on than just taxes. Investors look at a lot of factors when deciding how to value companies and their potential profits, and only one of those factors is the taxes that the company (or the investor) will pay. The economic situation and a given company’s growth prospects are much more powerful drivers of corporate profits and investment results.

Investors need to be aware of what may happen in the background as Congress tinkers with tax rates, but should not let that single factor drive investment decisions. Changes in tax policy are often very complex and take a while to ripple through capital markets. And in the current political environment, it’s not even clear that such changes will be enacted in the first place.

The far more important considerations as you manage your investment portfolio are your future earnings potential, your future spending needs, the valuations and future prospects of the investments you are considering and the health of the economy overall. A Fee-only CERTIFIED FINANCIAL PLANNERTM professional can help you figure out how these all come together for your portfolio.

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is directoriInvestment management with Blankinship & Foster, LLC, a wealth advisory firm specializing in financial planning and investment management for people preparing for retirement. Brooks can be reached at (858) 755-5166, or by email at Brooks and his family live in Mission Hills.

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