In this listener requested episode, we take a look at how taxes impact you as an investor. Understanding the maths behind all of the variables for your total return means you’re able to make better decisions. Tax is a big one.

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You’re able to find the transcript of the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Well, thank you for doing this, Shani, because Shani has been very busy, even though she’s still at work. She’s been very busy preparing for her trip to Europe.

Jayamanne: Yeah, this is us. We’ve been banking episodes, so you don’t have to go a week without Investing Compass episodes. This is our last one for five weeks.

LaMonica: Yeah. As soon as this ends, Shani will go back to preparing. You have collected more medical supplies than Europe was invaded with in World War II. There’s a reason for this. You got sick the last two times.

Jayamanne: Two times. It’s 100% strike rate at this moment.

LaMonica: Maybe you should stop going to Europe.

Jayamanne: Yeah, maybe. But yeah, it should be good. You’re also going on leave?

LaMonica: I am not as long.

Jayamanne: No.

LaMonica: I am going for less than half.

Jayamanne: Okay. Where are you going?

LaMonica: I’m going to India.

Jayamanne: Nice. And are you going to be there for your birthday, which is the 14th of April?

LaMonica: It is. We’ll leave my address in the show notes. You can send me a present.

Jayamanne: And your CFN, yeah.

LaMonica: Yeah, exactly. I will be there for my birthday.

Jayamanne: Okay. What are you doing?

LaMonica: On my specific birthday, well, hopefully I’m going to see a leopard.

Jayamanne: Love that for you.

LaMonica: Going on a leopard safari. So, and on my actual birthday, maybe I’ll see a leopard, or maybe I’ll just be in the like 38 degree Rajasthani heat and not see anything. The leopard will probably be hiding because it’s so hot.

Jayamanne: I’m sure you’ll have some way to cool off.

LaMonica: We will see. We will see. So, this is our -- we have another listener requested episode.

Jayamanne: We keep doing listener requested episodes.

LaMonica: I know because we’re out of ideas.

Jayamanne: It’s great for us.

LaMonica: We’re out of ideas. But this is a good one. The comment, where was it left? Because you encouraged people to do this.

Jayamanne: Well, it was left on Spotify, which is a reminder that any questions that you do have, you can put them on Spotify or YouTube or anywhere that you can reach us. Mark’s also got an email on the show notes that you can email as well.

LaMonica: You can also leave disparaging comments about me. And it would not be the first one.

Jayamanne: Or me. And it won’t be the first one. But anyway.

LaMonica: Be nice. So, we’ll go through the comment. It started out by saying, good podcast as always.

Jayamanne: Which is nice to hear.

LaMonica: Yeah. I think the R-E-A-T must have been broken on his phone because he put good instead of great. But anyway, the rest of the comment’s more important for this. So, I’ll read the rest. Something Mark said got me thinking, capital gains tax. People are so concerned about paying taxes on capital gains. Why? I hear this phrase often. If you’re paying more taxes, you’re making more money. Isn’t this just the cost of doing business and investing? It would be great to have an episode on the tax side of investing and the psychology of it.

Jayamanne: So, this is the old, you got to spend money to make money thing.

LaMonica: It is. You have to deal with the psychology side of things.

Jayamanne: All right. Why?

LaMonica: I don’t know. I’ve been told I’m not very sensitive.

Jayamanne: Okay.

LaMonica: We’ll leave that one to you. But we do want to preface this episode by saying that we of course support taxes. They are the price we all pay for living in a civilized society. Yes, taxes are the cost of doing well. Nobody’s going to turn down a pay rise because they pay more taxes. I certainly won’t if my boss is listening.

Jayamanne: I won’t either. And my boss is definitely listening.

LaMonica: Well, there we go. There we go.

Jayamanne: Yes. It is also important to understand mathematically how returns and compounding work. The more we understand compounding, the better our decision making is.

LaMonica: Okay. We talked about compounding a fair amount on this podcast, which I think is appropriate in investing podcasts, but repetition is one good way to learn. So, we’ll go through it again. Compounding is earning a return on a return. It is often cited. We hear about it all the time, but I still think people don’t fully understand it. How much it drives investment returns. So, the goal of every investor should be to minimize or eliminate any activity that breaks this momentum of compounding.

Jayamanne: A frequently used analogy of compounding is a snowball rolling down a hill. That snowball travels down the hill and it collects more snow and gets bigger. As it gets bigger, the speed increases and the larger surface area picks up even more snow. It gets bigger and bigger.

LaMonica: Yeah. So, there we go. It’s a really good analogy. If you think about it a little bit. The question was on taxes, but we do want to make it clear that anything that slows the momentum of compounding impacts the outcome you received. So, taxes, fees, transaction costs, and investment losses all hold you back.

William Ton: I’m Will producer of Investing Compass. And here are this week’s must reads on Morningstar.com.au.In this week’s Unconventional Wisdom column, Mark explores whether investor complacency is out of touch with reality. He looks at Game Theory and a Prisoner’s Dilemma and the lessons that investors can take from it, especially when it comes to the current market volatility. He looks at where Trump and the market might go from here. Finding superior long-term investments as a stock picker requires you to find companies that defy the laws of capitalism. But how might you go about doing this?

In the next edition of his Bookworm column, Joseph explores Marathon Asset Management’s capital cycle approach to investing and how it can identify so-called compounders. Joseph also highlights a holding from his portfolio that he thinks fits the bill. Successful investing doesn’t end as soon as you hit buy in your trading account. Shani’s Future Focus column looks at the methodical framework to monitor and maintain your portfolio to increase your chances of achieving your financial goals. Easy access to technology means younger generations are more informed and confident in their investment decisions more than ever. Furthermore, changes to the industry has led to structured financial advice increasingly becoming a luxury to access. In this week’s Young and Invested, Sim explores whether financial advisors have any real value proposition for young people. These articles and more they are now available in the show notes. Let’s get back to Mark and Shani.

Jayamanne: So we modeled out an example using taxes and we both understand the basis for the question. Taxes are owed no matter what, but the timing matters too.

LaMonica: Yeah, and there’s an obvious benefit to holding an investment for more than a year to get the long-term capital gains discount, that’s a 50% discount. We haven’t bothered to model out that scenario since we think everybody understands that. There’s also a benefit to paying taxes when you’re in a lower marginal tax bracket. So choosing when you pay taxes, we think everyone gets that. So we haven’t modeled that one out either.

Jayamanne: And in this scenario, one, we’ve assumed that an investor holds an investment for one year and one day that captures the capital gains discount. It is then sold and a new investment is purchased. That new investment is held for one year and one day. This process repeats over a five and 10 year period. Every time an investment is sold and a new one is purchased, the amount invested is reduced by the tax owed.

LaMonica: Okay, so that’s scenario one. Scenario two, the investor holds the investment for the entire time and just sells at the end of a five and 10 year period. Then the taxes are paid. The return in both scenarios is the same, which is 10% a year and the investor is in the same marginal tax bracket. So we did model this out for three different tax brackets, 45%, 37% and 30%.

Jayamanne: And we know that some of this can be difficult to follow in the podcast, but Mark wrote an article that has some tables that shows all the maths behind this.

LaMonica: Yeah, and just for the audio format. So the article has all three of those marginal tax rates. For the audio format, we’re just going to do one. So we’ll look at the 45% marginal tax rate. So after five years, if you follow scenario one and sell after year one and one day, et cetera, the total after tax return will be 45.24%. And if you follow scenario two, after five years, the after tax return will be 47.31%.

Jayamanne: And if you do this for 10 years in scenario one, you have a return of 110.95% and in scenario two, 123.52%.

LaMonica: Okay, so let’s break this down a little bit. As you can see, there’s a gap, even with the same return and the same taxes at the same marginal tax rate. As the time period increases, the gap gets bigger. So it’s 2.07% after five years and 12.57% after 10 years. So that is compounding.

Jayamanne: And maybe you’re surprised by the results, maybe you’re not. But what this shows is that the impact of breaking the momentum of compounding is real. And we will use a simple example with round numbers to illustrate what’s happening in the scenarios that we just modeled out.

LaMonica: Okay, so let’s say you start out with $100 and the investment doubles each year. So in scenario one, we take away 10% of your profits annually and the remaining money gets reinvested. Scenario two, we take 10% of the profits after two years.

Jayamanne: In the first scenario in year one, that $100 turns into $200. $10 is taken away of the $100 profit, leaving a total of $190. That $190 is doubled to $380. We take 10% or $19, which leaves $361.

LaMonica: In the next scenario, the $100 doubles to $200, then it doubles again to $400. We take 10% of the profits of $300, which leaves $370.

Jayamanne: And we’ve exaggerated the returns, which shows the impact of breaking the chain of compounding. There is value in delaying taxes, which means there is an advantage to longer holding periods. Many investors give up this advantage far too easily. So keep visualizing your portfolio as that snowball rolling down the hill.

LaMonica: And then think of all the things that slow the momentum of that snowball and avoid them in all costs. So this includes taxes, fees, transaction costs, and permanently losing money on speculative investments. Pushing all of this stuff into the future helps.

Jayamanne: Even small changes in momentum will make a big difference in how far that snowball rolls and how big it gets. Investors that don’t forget that end up in far better places.

LaMonica: So this was a short episode, as our last episode that we’re recording for a while. But we do think that this was a big lesson. And we certainly understand that you will pay taxes. That is natural and that is the thing that you have to do if you’re successful. But just remember what that’s costing you depending upon when those taxes are paid.

All right, so we will obviously have an episode every week, but we’ll be back after your trip to Europe to hear the stories of what illness dropped you down, Shani, in Europe.

Jayamanne: Look forward to that.

LaMonica: Yes. So thank you guys very much for listening. If you have any suggestions, throw them in Spotify, send me an email, put a comment on YouTube. We would appreciate it. Thank you.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)