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Market investors are primarily focused on market returns, as you should be; but another major component worth considering is how taxes impact your returns.READ THE ARTICLE
The market/tax relationship: The U.S. stock market returns about 10 percent per year based on nominal growth. To calculate how much taxes can deduct from that return, author Jesse Cramer collected 72 years’ worth of dividend tax rate and capital gains tax rate data, then divided it up into 10-year increments. Amongst each period, Cramer identified: The tax-free return, the dividend taxed/capital gains taxed return and lastly, how inflation impacted these returns.
The results: For the tax-free return, the average across all 10-year periods resulted in the textbook compounded return of about 10.4 percent per year. For tax-deferred accounts with income taxes factored in, that return went down to 8.8 percent per year. Then, for taxable brokerage accounts with dividend and capital gains taxes included, the return dipped further to about 7.2 percent annually. So collectively, taxes decreased total stock returns by roughly 41 percent.
Inflation impact: With inflation added to the equation, these totals continued to decrease; Tax-free returns went down to 6.8 percent, tax-deferred accounts, such as a 401(k), averaged 5.2 percent and the real return average of a taxable account equated to 3.6 percent per year. All of this is to say that while a popularly-cited 10 percent return seems rosy, growth of about three to four percent in taxable accounts is more realistic.
Run the real numbers: You shouldn’t take this as a sign to nix taxable accounts, but instead, a reminder to take that retirement calculator’s rates with a grain of salt and do your best to focus on maximizing your net.