Summary: Sell assets as infrequently as possible to minimize taxes.
Minimizing taxes is essential to long term returns.
Stocks incur taxes only when they are sold at a gain.
Shares sold within a year of purchase are subject to your ordinary income tax rate.
Shares held for more than a year are taxed at a much lower rate.
Interest income and dividends from stocks/bonds are taxed at ordinary income tax rates.
Recap: Cost minimization is the most important thing we as passive fund investors can do, as no other factor is more strongly correlated with higher returns (certainly not PE ratios or past performance).
To build on this, let's consider taxes, which are a significant component of your investment costs.
As with previous examples, we will assume you are in the 25% income tax bracket*, aka poor. The next highest bracket is only 3% higher, and to go higher than that you’d have to make about $200,000, so this is a reasonable assumption.
The bulk of our taxes is levied when an investment is sold at a profit, which is called a Capital Gain.
Short Term Capital Gains Tax = Ordinary Income Tax Rate
When you sell a share of a stock that you have held for less than 365 days, your capital gain will be taxed at your income tax bracket. Example: Your income is $38,000 (25% tax bracket) and sell 10 shares of GOOGL for $5 more than when you purchased them 100 days ago. Your capital gain is $50, and it is taxed at 50*0.25=$12.50. Your after-tax return is $38.50.
Long Term Capital Gains
When you sell a share of a stock that you have held for at least a year, you pay the (long-term) capital gains tax. Here’s a chart:
In a mutual fund, assets can be sold by the manager at any time to result in a capital gain. This occurs much more often in an actively managed fun.
Dividends and Bond Earnings / Interest Income
Some stocks pay dividends to the shareholders, and just like regular bond payments (which is interest paid to you), these are taxable.
These are taxed at ordinary income rates, and there is no discounted rate. Thus, they are tax-inefficient.
Selling at a loss can reduce your tax load on any capital gains you have. This is called tax loss harvesting.
This is a bare essential guide to taxes. To minimize your tax loss, you should hold shares for at least a year and sell them as infrequently as possible. One thing I did not emphasize in this article is just how large the impact of taxes is on returns. It's huge. Bear and Bull markets last several years, so don't be tempted to sell a stock just because it's high and you've held it for longer than a year. Almost always, the best option is to do nothing.
You may have heard of tax-sheltered accounts, and I will explain those in the next article. Accounts such a traditional IRAs, Roth IRAs, and 401ks significantly reduce taxes, which makes tax-inefficient investments such as corporate bonds and high-dividend stocks much more appealing.
*2013 individual income 25% tax bracket: $36,251–$87,850