Tax rates remain low historically speaking.
But, tax rates tend to have little empirical effect on stock market returns.
Whenever tax rates change, there’s an opportunity for investors, retirees and their advisors to arrange their portfolios in a tax-efficient manner and to create valuable tax savings.
In theory, the much ballyhooed reduction of taxes on both the personal and corporate level would seem to be great for the economy and for investors, but history suggests that tax rates have little impact on investor returns.
Figure: Tax Rates and Stock Returns. Sources: Standard & Poor’s, Bloomberg, Tax Foundation
The chart above plots both the maximum federal income tax rate by year and the average annual return of the S&P 500 for the past five years, both through the end of 2012. These returns are smoothed over five years to make the trend easier to see and to help us focus on longer-term effects. A number of interesting patterns emerge from the figure.
First, you’ll notice that tax rates were much higher in the past. If you believe in mean reversion, as is often the case with investment management, then tax rates could be going higher. Indeed, we have seen higher rates this year, and there is talk of further increases. Even after the latest increase, however, rates are still low compared to where they have been. And no one is discussing increases of the magnitude that would bring tax rates to where they were in the 1950s through the 1970s.
Another thing to note from the figure is the relation between tax rates and stock returns. In particular, there is not much of a relation at all. Correlations are actually slightly positive, although not statistically significant. Rather, we have had both high and low stock returns when taxes were higher and high and low stock returns when taxes were lower. While it may seem intuitive that higher tax rates are a threat to stock returns, the historical evidence simply does not back this up.
What the trends mean for advisors
The effects of taxes are not just financial; they contain emotional and political ramifications as well. Emotionally, investors may complain and worry about the impact of higher tax rates at the personal, corporate and estate level. While nobody likes having more money taken out of their paychecks, remember that rates are relatively low, historically speaking. You should also note that stocks can do quite well during periods of higher tax rates, too. One should generally be wary of discussing politics, but note that tax-efficient techniques are found on both sides of the aisle.
Another crucial point is that investors generally did not pay the highest tax rates seen in the chart. Instead, they used tax shelters and other tactics to keep their effective tax rates much lower. While the tax reform that brought about lower rates also ended many of the tax shelters that were used, there are still a variety of techniques that investors can utilize to lower their taxes. These techniques include:
Tax-sensitive investments in taxable accounts.
Funding tax-deferred and tax-exempt accounts and using them for effective asset location.
Integrating tax considerations in decisions such as estate planning and charitable contributions.
If you or someone close to you has concerns about the implications of tax reform on their investments or tax situation, we’d be happy to discuss with you please click here to schedule a call.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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