The Tax Cost of Turnover

Yesterday’s post discussed the costs of turnover in your account—the selling and buying of stocks. I thought it would be instructive to quantify the tax costs of turnover to see just how much it’s worth worrying about. It turns out that over time, the tax cost can be meaningful. Remember, this discussion only applies to taxable investment accounts, since turnover inside tax-favored retirement accounts is tax-neutral; it carries no tax cost.

Let me describe two little experiments. The first applies to those who are not yet retired and are still accumulating assets and the second applies to those who are in retirement and spending down their assets.

The first experiment. Picture a hypothetical person just like you (but not as good looking). At age 30, he’s got $1,000,000 of cash to invest, which he intends to invest 75% in stocks and 25% in bonds. His goal is to accumulate a retirement fund at age 65. Assume all gains are long-term capital gains, and there are no commission costs. Applying reasonable assumptions, with very modest turnover (1% per year, which is about right for an index fund), he can expect to accumulate $4,512,913 in real (inflation-adjusted) dollars, after taxes.

Now change just the turnover assumption to 70% annual turnover (not unusual for an actively managed stock fund). Capital gains tax costs lower the after-tax accumulation at age 65 to $3,677,357. That’s a 19% drop in the retirement fund, which would likely translate into a 19% drop in available retirement spending. Small costs add up!

Now the second experiment. Picture someone age 65, with a $5,000,000 taxable account. She plans to spend an amount which will leave her children with half her wealth remaining if she were to die 30 years hence at age 95. She plans to invest her account 50% in stocks and 50% in bonds. Assume only a modest 1% turnover, and her after-tax allowance from this taxable account is $208,050. Change that turnover assumption to 70%, and her after-tax allowance drops to $190,225. That’s a 9% cut in lifestyle.

Again, turnover matters.