Even here at Betterment, our mantra is:
Maximize clients’ returns, net of risk, fees, time, taxes and behavioral mistakes.
But there’s a point of diminishing returns—or false economy—when the quest to avoid taxes on your income or investments becomes a determined tax aversion that costs more than it’s worth.
In fact, a 2011 study by two colleagues of mine indicates that many people get so focused on avoiding taxes, and keeping that burden as low as possible, that they actually sacrifice higher potential net-of-tax returns.
Blinded by taxes
Abigail Sussman, professor at the University of Chicago, and Christopher Y. Olivola of Carnegie Mellon found plenty of evidence of irrational tax aversion across a number of experiments—including a willingness to wait longer for a tax-related discount (versus an identical discount that wasn’t tax-related), and a preference for a tax-free bond over one where the yield was taxed, even though the net gain was the same.
In the first instance, we all know that time is money, yet people were willing to “pay more” in time spent waiting for a tax-related discount, compared to a non-tax-related discount of equal value.
The researchers set up two sales for unwitting shoppers: one billed as a “sales tax holiday”, and another just a sale for exactly the same percent discount. The median respondent was willing to wait 26 minutes for the non-tax discount, but 32 minutes for the tax-related discount, of equal value. So the participants seemed willing to “pay” with more of their time to get around paying something that involved the word “tax”—even though it wouldn’t result in additional savings.
Another example is relevant for investors who attempt to avoid taxes by having municipal bonds in their portfolio.
Research revealed that 77% of participants preferred a bond that earned $300, compared to one that earned $400 with a tax of $100. Both bonds offered the same return, but the participants strongly preferred the version which avoided tax.
As Sussman and Olivola note, this result helps to explain “the suboptimal tendency of lower tax-bracket investors to purchase tax-exempt bonds instead of taxable bonds that provide superior after-tax yields.”
More than words
It’s strange to think that simply couching a scenario in terms of taxes can be such a powerful influence over people’s decision-making.
As the authors note, the dislike of taxes should directly relate to the cost imposed—at least in economic theory. In reality,”people may dislike taxes above and beyond their ﬁnancial costs, for cultural, political, or even moral reasons.”
What they demonstrated in this series of experiments is that in every case, people tended to exhibit an irrationally strong preference for avoiding costs perceived as taxes—whether by incurring longer waits, longer commutes, or higher risk.
Minimizing after-tax gains
In making investing decisions, this tax aversion can manifest itself in the following manner. Some investors get confused between minimizing taxes and maximizing net-of-tax returns. These are two different things.
A quick refresher on investment taxes—the following is illustrative, and individual circumstances vary, but this applies to all but very unusual situations (try to not fall asleep—it’s important!):
- You pay income tax on ALL realized investment income, whether it’s interest in a savings account, or dividends in your investment portfolio.
- There are NO circumstances under which you’ll be taxed more on a dollar of growth on your investments than in a savings account. There ARE circumstances under which you’ll pay less tax on the same return in your investments, compared to a savings account.
- You ONLY pay capital gains tax when you sell an investment which has risen in value. If it falls in value and you sell it, you get a capital loss which can offset other gains, and you owe no tax.
- You pay tax ONLY on the gains, NOT on the full amount invested. If you invest $100, and it grows to $140, you’ll only owe tax on the $40.
- Though it depends on your income and marginal tax rate, the most the federal government would tax you on gains from short-term investments (held for a year or less) is 43.4% (your income tax rate). In that case you’d end up with about $122. [$140 – ($40 * 0.434%)]
- If it’s a long-term investment (held for more than a year), you’ll owe between 0% and 23.8% tax. Meaning, you’ll end up with somewhere between $130 and $140.
A classic behavioral mistake
Unfortunately, the desire to minimize taxes can likewise lead you (inadvertently) to reduce gains below what they could have been.
Here’s an example we often hear:
I don’t want to invest my [medium-term goal] in Betterment because I’ll be withdrawing it in two or three years, and I don’t want to pay capital gains taxes.
Incurring a tax liability is an understandable concern. But in this case, you would only pay more taxes if you made more money! The alternative—i.e. putting the money into a savings account—has two downsides. First, you’re not likely to earn more than, say, 1% on your savings account these days. But even if the account had an interest rate that equaled the return on your Betterment account, that gain, because it’s interest, would be taxed at the same rate as capital gain on a short term investment (up to 43.4%, as above).
A portion of the gain in your Betterment account after two to three years is likely to be taxed at long-term capital gains rate (up to 23.8%, from above).
At worst, for the same gross return, you’d end up with the same net-of-tax gain. But it’s more likely that you’d get a higher net-of-tax return when your gain comes from a long-term investment, because there’s opportunity to be taxed at a lower rate. Interest in a savings account won’t ever qualify for such lower tax rates, no matter how long the money sits there.
So what’s our advice? Focus on your after-tax returns, not the taxes themselves. This will help you concentrate on what really matters, and not end up paying less tax because, alas, you’ve earned less money.