TAXABLE-ACCOUNT investors are encouraged to hold winning investments for more than a year, so that the appreciation is taxed at the long-term capital gains rate, rather than at the higher income tax rate. But arguably, you should set your sights not on 12 months, but on 20 years and preferably longer.
Why? By holding onto a winning investment, you defer the capital gains tax bill. But to milk the most out of this tax-deferred growth, you need extraordinarily low portfolio turnover. This was the key insight in a 1993 Journal of Portfolio Management article written by Robert Arnott and Robert Jeffrey, and titled “Is Your Alpha Big Enough to Cover Its Taxes?”
Let’s say you own a stock mutual fund with 100% turnover, which means it typically holds its investments for 12 months. Even if you swap into a fund with 50% turnover, the typical holding period would only be 24 months. That means the fund is deferring taxes for just two years, which isn’t a great benefit.
Instead, if you want to get tax deferral in a taxable account that’s financially meaningful, you need a portfolio turnover rate of just 10%, which implies a 10-year average holding period, or even 5%, which would mean a 20-year holding period. You could achieve that sort of tax deferral by buying and holding individual stocks or by purchasing broadly diversified stock index funds, most of which have modest turnover.
This is a lesson some investors learn too late: They buy actively managed stock funds in their taxable account, which then make large taxable distributions each year. These investors find themselves in a quandary. If they sell and swap to index funds, they would suffer a big onetime tax hit, as they realize capital gains on the funds they currently own. To avoid this dilemma, think carefully about the investments you buy for your taxable account—and favor those that you would happily hold for many decades and that should generate modest tax bills.
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