Are you beating the market after taxes? It seems like a simple question, but it’s not so simple to answer. Measuring performance before taxes can be done in the blink of an eye with some easy arithmetic, as long as you have returns for your portfolio and a commonly referenced index. But when you’re measuring performance after taxes, there’s no such reference point. If you want to know how you performed after taxes, you would need to calculate your own personal index—not a simple task.
This lack of information is the biggest reason many investors are left in the dark about the tax efficiency of their portfolio. Let’s explain why after-tax performance is so mysterious and what to do about it.
How do you calculate after-tax performance?
There are three key things that determine a US investor’s after-tax performance:
- Tax rate
- Timing of contributions or withdrawals
- Unrealized gains or losses in each security, which depend on the timing of their purchase
Every time a security is sold, an investor must pay tax on the difference between the purchase price and the sale price. If the sale price is greater than the purchase price, the investor owes tax. If the price is lower, they have a loss they can use to reduce capital gains or up to $3,000 of ordinary income. Anything they can’t use in the current tax year can be carried forward to future years.
Why aren’t there ready-made after-tax benchmarks?
None of these things translate easily to a standardized benchmark. Even if the benchmark matched the investor’s tax rate, it would be quite challenging to create enough permutations for it to anticipate the exact timing of each security purchase or sale for any given investor. Never mind the poor investor’s job of trying to sort through all the variations to find the one that matches their situation. But without that, the after-tax benchmark is as good as useless.
Consider a fully invested portfolio in which most of the securities have unrealized gains. A withdrawal from that portfolio would require selling securities, which would likely result in realizing gains. The magnitude of those gains depends on how greatly the securities had appreciated since the original purchase.
How should we frame the benchmark? If it doesn’t have commensurate embedded gains in its holdings, the tax on a hypothetical sale of a security in the benchmark would trigger a smaller tax bill. If you measured a portfolio with many unrealized gains against a benchmark without them, the portfolio would always look worse than its benchmark on an after-tax basis. But this would have nothing to do with the manager’s skill at managing withdrawals in a tax-efficient way—just a mismatch in assumptions around the timing of the original purchases. In other words, even though there are better or worse ways to choose which securities to sell, it’s hard not to trigger any taxes when all you have to choose from are securities with unrealized gains. If the benchmark doesn’t trigger the same gains because it doesn’t have similar embedded gains, it would be misleading to represent it as though it were simply managing realized gains better.
Similarly, if the portfolio had large and widespread unrealized losses, its after-tax returns might look much better than an after-tax benchmark without those same unrealized losses. This doesn’t necessarily mean that the manager was especially clever at tax-efficient trading. It only means they were up against an easy-to-beat reference point.