ELITE ADVISOR BEST PRACTICES

The Effect of Taxes on Stock Returns

And the opportunity for advisors

By Glenn S. Freed

Key Takeaways:

  • Tax rates have gone up this year, causing investor concern, but they’re rather low historically speaking.
  • Tax rates tend to have little empirical effect on stock market returns.
  • Higher tax rates create an opportunity for the elite advisor to help clients arrange their portfolios in a tax-efficient manner and to create valuable tax savings.


With April 15 finally behind us, investors have been focused on taxes, both for the 2012 returns that have just been finished as well as for the current year. The highest marginal income tax rate has gone up this year to 39.6 percent, long-term capital gains and qualified dividends have increased to a maximum of 20 percent, and there is a new 3.8 percent Medicare tax on investment income. Additionally, the 2 percent cut in the employee’s portion of the Social Security tax was allowed to expire. Discussion of further tax increases continues. A number of articles in the media have warned of the headwinds these increases potentially pose for the stock market. Let’s take a look at the historical evidence and discuss the opportunities available for the elite advisor.

Glenn Freed Headshot

Figure: Tax Rates and Stock Returns. Sources: Standard & Poor’s, Bloomberg, Tax Foundation, Author

The chart above plots both the maximum federal income tax rate by year and the average annual return of the S&P 500 for the past five years, both through the end of 2012. These returns are smoothed over five years to make the trend easier to see and to help us focus on longer-term effects. A number of interesting patterns emerge from the figure.

First, you’ll notice that tax rates were much higher in the past. If you believe in mean reversion, as is often the case with investment management, then tax rates could be going higher. Indeed, we have seen higher rates this year, and there is talk of further increases. Even after the latest increase, however, rates are still low compared to where they have been. And no one is discussing increases of the magnitude that would bring tax rates to where they were in the 1950s through the 1970s.

Another thing to note from the figure is the relation between tax rates and stock returns. In particular, there is not much of a relation at all. Correlations are actually slightly positive, although not statistically significant. Rather, we have had both high and low stock returns when taxes were higher and high and low stock returns when taxes were lower. While it may seem intuitive that higher tax rates are a threat to stock returns, the historical evidence simply does not back this up.

What the trends mean for advisors

There are several implications for advisors and how they can benefit their clients. The effects of taxes are not just financial; they contain emotional and political ramifications as well. Emotionally, clients may complain and worry about the impact of higher tax rates. While nobody likes having more money taken out of their paychecks, remind them that rates have been higher. You should also note that stocks can do quite well during those periods of higher tax rates. One should generally be wary of discussing politics, but note that tax-efficient techniques are found on both sides of the aisle. As their recent tax returns show, both Mitt Romney and Warren Buffett agree: arrange your portfolio to reduce taxes.

Another crucial point is that investors generally did not pay the highest tax rates seen in the chart. Instead, they used tax shelters and other tactics to keep their effective tax rates much lower. While the tax reform that brought about lower rates also ended many of the tax shelters that were used, there are still a variety of techniques that an advisor can utilize to help clients lower their taxes. These techniques include:

  • Tax-sensitive investments in taxable accounts
  • Funding tax-deferred and tax-exempt accounts and using them for effective asset location
  • Integrating tax considerations in decisions such as estate planning and charitable contributions

We and our Elite Advisor Report colleagues have written about these topics a great deal and look forward to further discussions in the future.

The increase in tax rates thus presents an opportunity for the elite advisor. The higher the rates, the greater the role that a comprehensive tax treatment plan has in a client’s overall financial planning. The potential benefits for your clients are both qualitative and quantitative, leading to tax savings that can be directly measured. And perhaps this will make clients feel better next April 15.


About the Author

Vericimetry is an academically based, quantitatively structured investment adviser providing capacity-constrained asset class strategies to an exclusive group of elite financial advisors. Website: www.vericimetry.com.

Glenn S. Freed, PhD, CPA, PFS, is a leading investment and tax expert in the investment management industry. Dr. Freed is the Chief Executive Officer of Vericimetry Advisors LLC, which intends to make necessary filings to become an investment advisor registered with the Securities and Exchange Commission during 2011. Dr. Freed has 25 combined years of experience in investment management, tax and accounting research, education, and tax advising. He received a PhD from the Graduate School of Business at the University of Southern California and a BS in accounting from the University of Florida.

Phone: (818) 813-1351