Death and Taxes at year end: Unpredictable Certainties

There is one trading day left in the year and thus one last day for last-minute tax planning. More than any year in living memory, this one is unsettled simply because no one knows what the tax code will look like for either corporations or individuals next year. As a consequence, I have found that taxes have dominated my thoughts about investing for the last couple of weeks and that makes me uncomfortable, since some of the least sensible investment choices I have made in my lifetime have come about when tax considerations have been preeminent. To ground my thinking and actions for these last few weeks, there are three propositions about taxes that I have had to remind myself about repeatedly over the period.

1. The objective in investing is not to minimize taxes paid but to maximize after-tax returns
If you hold pre-tax returns constant, your objectives when it comes to taxes are simple: you want to pay less taxes rather than more, and later rather than sooner, and that is precisely what most tax advantaged investments offer as their selling points. The catch, though, is that you generally have to accept lower pre-tax returns in return for these tax advantages and it is often the case that these tax advantaged investments generate lower after-tax returns than conventional alternatives. An investment strategy built around minimizing taxes can lead to bad choices. Do you want an investment strategy that ensures that you pay not taxes next year? That's easy!  Just buy non-dividend buying stocks that go down over the course of the year!!

I was reminded of this simple proposition as I was considering the coming changes on capital gains taxes, the one aspect of the tax law where we know what next year will bring. The long term capital gains tax rate, which was 15% for the last decade, will jump to 20% for all investors on January 1, 2013, and to 23.8% for those investors who have more than $200,000 in income; the additional 3.8% is the tax on investment income that was part of the Patient Protection & Affordable Care Act of 2010. Thus, if you have $100,000 in capital gains on a stock, selling it on December 31, 2012 will result in a $15,000 capital tax, but selling it later in 2013 will generate $20,000 ($23,800) in taxes. While my first reaction was that I should sell my big long-term (held > 1 year) winners this year and save on taxes, I had to caution myself to go slow, since the savings in capital gains taxes have to be weighed against the value lost by selling early, if the holding in question is still undervalued.  I ranked the investments in my portfolio, based upon absolute capital gains and then revalued each of the five stocks at the top of the list, using updated information. The three stocks that were still under valued (based on today's price and updated valuation) by more than 5% remained in my portfolio, whereas the two stocks that were under valued by less than 5% or were fairly valued (or over valued) were sold. If you don't have the time or the inclination to do a full fledged valuation, you can still ask yourself a question about your big winners: Would you buy the stock at today's prices? If the answer is yes, you should be hold back on selling the stock, even though capital gains taxes are going up next year.

I know that next year will bring more of these trade offs. With dividend taxes, where there is more uncertainty,  the worst case scenario is that they revert back to being taxed as ordinary income. For investors making over $250,000 in income, this could translate into a tax rates as high as 43.4% (assuming that the higher income tax rate reverts to 39.6% plus 3.8% in healthcare taxes). While my first reaction again is that if this scenario unfolds, I should avoid stocks that pay large dividends, I know that that reaction may not be a sensible one. After all, the prices on these stocks could fall to make their returns attractive enough that even with the higher taxes, they are good investments.

2. Look for value first, think about taxes afterwards
When valuing companies, I believe it is best to keep personal taxes out of the analysis, since it is not your tax status or mine that is the determinant of the intrinsic value of a company. That value should be estimated from the perspective of the marginal investors in the company, i.e., investors who own large proportions of the stock and trade it, rather than your own. That is why we measure risk as perceived by those marginal investors (who we assume have diversified portfolios) and that is also why it is their perception of taxes that will determine intrinsic value. Thus, if the marginal investors in P&G and Coca Cola are pension funds (and thus unaffected by dividend tax law changes), it is possible that the intrinsic value of these companies may not change, even in the worst case scenario where the tax rates double on dividends.

Having estimated the intrinsic value of these companies, I can bring my tax status into the mix, when making my choices. Thus, if I have to pay a 40% tax rate on dividends and a 20% tax rate on capital gains, and I have to choose between two equally undervalued companies, one with a high dividend yield and one without, I would pick the latter. If the higher dividend paying stock delivers a higher pre-tax return than a stock of equivalent risk that does not pay a dividend, I will then have to work out the after-tax returns that I will get from each to make my final judgment. For example, if I expect to generate a pre-tax total return on 10% on a stock with a dividend yield of 2% and 9% on a stock that has no dividends, the after tax returns on each would be as follows (with a 20% tax rate on capital gains and a 40% tax rate on dividends):
After-tax return on a stock = (Total return - Dividend yield) (1- Capital gains tax rate) + Dividend yield (1- Dividend tax rate)
After-tax return on dividend paying stock = (10%-2%) (1-.20) + 2% (1-.40) = 7.6%
After-tax return on non-dividend paying stock = 9% (1-.20) = 7.20%
For the last decade, I was able to skip this step as the tax rates on capital gains and dividends converged, but it is a step that I cannot ignore if the tax rates on dividends and capital gains diverge again.

3. Having a long time horizon is the best protection against taxes
As investors look for ways to reduce the tax drag on their investments, they will be tempted by complex products that will claim to save them taxes. For some of the very wealthy, these products may make sense, but for the rest of us, they often create more costs than benefits. I may be simple minded when it comes to taxes but I think that the most effective tax management strategy for most investors is to have a long time horizon. Investors with short time horizons generally pay more in taxes for two reasons: (1) their holding periods are too short to qualify their gains for long term capital gains, thus converting their price appreciation in ordinary income (with higher tax rates) and (2) the high turnover in their portfolios makes it impossible to have a cohesive tax strategy.

The link between turnover and taxes is most easily seen when you look at returns on mutual funds, where Morningstar keeps track of the pre-tax and after-tax returns on funds. The figure below provides the statistics for the tax drag for funds broken down by turnover ratios (total trading volume/ value of the fund) for a five year period (2006- 2010):

While the returns on all funds were depressed by the poor market returns during this period, what is noteworthy is the tax drag (the different between pre-tax and post-tax returns) as a function of turnover ratios. The funds with the lowest turnover ratios (and the highest time horizons) had the lowest tax drag, whereas those fund that had short holding periods and high turnover ratios paid much more in taxes.

In closing
At this point in the fiscal cliff debate, I am resigned to the fact that taxes will go up on January 1, 2013 and the only question is by how much. I have done all I can with my existing portfolio to reduce the impact of the tax law changes, but I have had to restrain myself from over reaching. It is possible that we will know what the tax code will look like before close of trading on December 31, 2012, and the market reaction to those changes will play out over the next few days. For my part, I am done with investing for the year and will spend tomorrow on more important concerns- friends, family and faith. Death and taxes may be unavoidable, but life is too short to be spent obsessing about either. So, have a happy new year and may it bring you health and happiness!!