In this short blog post, I’m going to give you one more reason to invest for the long-term: to avoid taxes.
This is not an original idea of mine. Indeed, it’s widely known and has been for a long time. But it’s so important, I want to write it down in my own words here.
Also, if you are investing in an ISA or some other CGT-exempt account, then this concept is perhaps less relevant for you. This concept is relevant for everyone who is liable to pay capital gains taxes (CGT).
Suppose I invest £100 in Super Stock Plc. Suppose for the sake of argument that all of my capital gains are taxable at 25%. We will ignore transaction costs.
Let’s imagine that shares in Super Stock double in price over some time period, and I am thinking about selling.
Although my holding is now worth £200, I will face a 25% CGT charge on my £100 of capital gains, if I sell. So after paying £25, I will be left with £175.
I can reinvest and put this £175 to work again, but now I have less capital working for me than I did before.
To complete the thought experiment, let’s compare the two circumstances (selling and reinvesting, versus not selling and staying invested). Let’s see if we can figure out what gross return is needed subsequently to be left with a value of £200 after tax liabilities.
Scenario 1 (Selling and reinvesting)
We have £175 after paying £25 of CGT.
To achieve a value of £200 after tax liabilities, we need to subsequently earn about 19%.
£175 * 1.19 = £208.25 with tax liability of £8.31 (25% of the gain from £175 to £208.25).
After paying the tax liability, we are left with approximately £200.
Scenario 2 (Staying invested)
We have £200 invested, with a £25 CGT liability attached.
To achieve an after-tax value of £200, we only need to earn a further 16.7%.
£200 * 1.167 = £233.4 with tax liability of £33.35 (25% of the gain from £100 to £233.4).
After paying the tax liability, this scenario also leaves us with approximately £200.
In case you think I am exaggerating the effect or playing with the numbers: this effect can actually be a lot more extreme, especially with larger accumulated capital gains.
By delaying the payment of your CGT, you get to have more capital working for you for longer. As Warren Buffett has said, the deferred CGT liability is equivalent to getting an interest-free loan from the government. Using this loan instead of repaying it means that your portfolio doesn’t need to work so hard, to get the same after-tax return.
This means that if you are liable to CGT, it can make sense to leave your capital at work in your successful investments for much longer periods than you otherwise would. It’s another reason to be cautious about chopping and changing your positions, and to do so only when your conviction levels are suitably high.
It makes share prices less efficient, but it’s a fact of life for many of us and an important financial lesson.