The Consequences of Trading and Tax on Long Term Investment Gains
How taxes cause two investments earning the same rate of return to result in $1M vs $130M
I think it is quite counterintuitive how much paying taxes affects your investment gains over time. Most people think there isn’t much difference between the gains one makes via trading (hence paying tax) vs holding long term, if the percentage gains are the same.
I think Buffett’s 1993 letter is especially instructive at showing the magnitude of the difference over time:
Reinvest in multiple companies, or hold one compounder?
“Said the sage: Double your money 20 times and Appassionatta will be yours (1, 2, 4, 8 . . . . 1,048,576). Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 7 1/2 years more to reach the $1 million required to win Appassionatta.
But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27 1/2 times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about $130 million after-tax.
What this little tale tells us is that tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate. But I suspect many Berkshire shareholders figured that out long ago.”
To make this more realistic, let’s assume a 20% long term capital gains tax rate and a 20% gain every year, starting with $100,000. By compounding in one stock for 20 years and paying tax at year 20, you’d have $3.1M. Compounding at the exact same rate with a succession of investments (buy sell buy sell every year) would lead to just $2.1M after taxes, or $1M less. By year 40, the difference is $118M vs 46M.
Why the large difference?
What’s happening is that the amount you pay in taxes every year is not being allowed to compound. By allowing it to compound, you both pay a larger tax bill, but also take home more.
Of course, this doesn’t affect you if you’re a citizen of a country like Singapore, where taxes on capital gains are minimal.
If you have the ability to time the market, you will still generally do better by timing the market correctly and achieving additional gains despite paying short term taxes. You can play around with it in excel. Nonetheless, even for traders, I think it is important understand the tax consequences of trading.