How taxable accounts are affected by turnover

Taxable Accounts Need Different Strategies. If you're in the highest tax bracket, capital gains taxes can devour a large part of your alpha.

Many investors fail to consider the tax consequences of turnover in their portfolios. Throughout this article, we will demonstrate the pre-tax alpha versus post-tax alpha for different levels of outperformance.

Here's the setup. The portfolios are in taxable accounts. The passive portfolio holds 1 stock indefinitely. The active portfolio holds one stock and at the end of each year, the stock is sold and replaced with another stock. The gain on the stock is taxed at the top marginal capital gains rate of approximately 24%. If you live in a state where capital gains is taxed (NY or CA for example), your tax rate could be substantially higher, thus your post-tax alpha will be lower.

Let's dive into the numbers. In the passive portfolio, you buy and hold a stock that averages an 8% gain over a long period of time, you can include the stocks in your estate and your beneficiaries will get the step up basis on your portfolio and pay Zero tax on your capital gains.

In the active portfolio, we include both a 1-year and 3-year holding time. The pre-tax column, as you would expect, provides the gross amount before you write the check to the IRS. The post-tax column is what's yours to keep. We show these pre- and post-tax returns for both holding times.

Bottom Line:

If you turn your portfolio over once a year and achieve a pretax return of 9% (an alpha of 1% versus the passive portfolio), your after tax return will be 6.84%. If you're a star and you're able to manage an 11% annual pre tax return (an alpha of 3%), your post-tax return will be 8.36%. That's better than the passive portfolio, but not by much, and typically requires a significant time investment.

The takeaway is that if you're trading in a taxable, there's a significant benefit to buying quality companies that you want to hold for the long term versus buying companies that are attractively priced, but might not fit your long term outlook for the market.

The obvious next question is what will happen if I sell my stock after 3 years or 15 years instead of after 1 year?

The answer isn't intuitive. Remember, the base case stock or index was going to gain an average of 8% per year. If you're a star manager and you can consistently outperform the market by 300 basis points (averaging 11% return per year), your after-tax alpha if you turnover your portfolio each year is a stingy 0.36%. Now we're looking at turning over the portfolio every 3 years. In that case, your after-tax alpha skyrockets to 0.56% (56 basis points). Not the huge difference you might be expecting. If you extend your portfolio turn around time to 15 years, then you see a significant difference. That alpha is 1.45%.

Warren Buffett says his optimal hold time is forever. The tax implications of frequent turnover is most certainly a factor in this strategy. Does this mean you should buy an index instead of individual stocks? Not necessarily, but it does mean there's a big headwind (in taxable accounts) when you're buying with a short-term view. If you own a stock that you think is in secular decline, selling might be the best option. If on the other hand, you think that a stock in your portfolio might underperform its replacement by a percent or two, you should consider your unrealized gain in that stock.

For example, Buffett has a large position in Coca Cola. The stock is in the low 60's(let's call it 60 as it makes the math easier) and I think his cost basis is around $4. Let’s assume he had the stockin his personal holdings instead of Berkshire so the tax implications would be similar to most individuals reading this article. The current Federal Capital gains tax maxes out at around 24%. If you live in CA, you can add more than 13% to that number. If Buffett were to sell the stock at $60, he’s pay capital gains on the $56 increase in the share price. His net proceeds from the sale would be, $60 minus $13.50 for Federal Capital Gains Tax, net to Warren of $46.50.

If Coke grows at 6%/year, its replacement has to grow much faster to make up for the fact that it started at $46.50 (his after-tax proceeds) versus the current share price of Coke ($60).

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Examine the chart to see what would happen if Buffett sells his Coke stock at $60, pays his tax and buys another stock selling at $46.50 (the amount he has to re-invest after taxes). This chart assumes that Coke grows at 6%/year and the stock he purchases grows at 9%/year. After 10 years, the Coke stock is trading at $107.45 and the replacement stock is $110.08. This doesn't account for potential differences in dividend yields. Over the 10 year period, the replacement stock grew close to 137% while Coke grew at around 80%. In a taxable account, turnover matters. If you're in a high-tax state, the returns will look even worse for the replacement stock.

The chart below shows how taxes on turnover affect alpha. These numbers are based on turning over the portfolio annually.

Warren Buffett's strategy is to buy high quality companies he can hold forever. After looking at the numbers above, you can probably recognize that it's a laudable strategy. He used to purchase lower quality companies at distressed pricing and then sell them when the pricing recovered. He was very successful with this strategy but it exposed him to the tax penalty in the above table. In a taxable account, 5% of annual alpha (superstar quality) translates into 1.88% alpha if you have turnover. We didn’t mention the fees that a super-star, 5% alpha generating, manager would charge.

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