The Tax Bite Is Bigger Than You Think

Tim Strauts: In today's chart, we are going to look at stock and bond returns, before and after taxes, since 1926. Before we get to the chart, we are going to look at the methodology used to calculate our after-tax returns.

Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs.

When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. Finally, no state income taxes are included.

Now, looking at the chart, you can see that stocks before taxes have had a return of 10.1% annualized, and $1--starting in 1926--grew to $4,677 by the end of 2013. But when we adjust those returns for taxes, our returns go down to 8.1% and that $1 only grows to $934, which is actually five times less money. So, you can see that 2% less returns compounded over many years has a big impact on your final dollar value.

Now, when we look at bonds, you can see bonds before taxes had a return of 5.5%, and $1 grew to $109 by the end of 2013. But when adjusted for taxes, the return goes down to 3.4% and that $1 only grows to $18. So, for bonds, it's even worse. You have six times less money over the entire period.

In today's environment, where stock and bond returns may be lower than the historical average, it really pays to watch taxes going forward. So, you really should take advantage of any tax-deferred retirement vehicles and tax-efficient trading strategies.