The tax benefits of long-term investing in ETFs

In 1966, the Beatles released the song Taxman as the opening track on the album Revolver. Its lyrics start, ‘Let me tell you how it will be. There’s one for you nineteen for me. ‘Cause I’m the taxman. Yeah, I’m the taxman’.  

The song was written by George Harrison, and was inspired by UK tax law, whereby the earnings of the Beatles had placed them in the top tax bracket, meaning that they were liable for a 95% supertax. 

The tax law was introduced by Prime Minister Harold Wilson, and almost resulted in the Beatles going bankrupt, as most of the substantial cash they earned, was paid back in taxes. 

The Beatles eventually set up Apple Corps, which enabled them to sidestep this super high tax, and instead pay their taxes at the lower corporate tax rate. 

Of course, paying taxes are good for the country, but there is nothing wrong with reducing your taxes when it’s perfectly legal to do so. 

One of the most effective ways to reduce your tax is also one of the easiest, and that is to invest for the long-term. 

Buy and hold investment strategy 

Let’s assume you are invested in a well-diversified portfolio or a broad-based ETF, which pays dividends or distributions in line with the broader market.  

If you sell that investment, not only will you attract brokerage costs, but you could also attract capital gains tax (assuming your investment has gone up in value). When you pay this tax, that money is gone forever, and will reduce your investment capital. On top of this, your dividends may reduce too (in line with the reduction of investment capital). 

The eye-opening maths of doing nothing 

The mathematics of why long-term investing works out better than short-term investing (from a tax perspective), is explained by Berkshire Hathaway Vice Chairman Charlie Munger. 

Please note that this example is based on the American tax system, which is quite different to that of Australia, but the same principles apply. 

Munger gives the example of a company that compounds its profits at 15% for 30 years. 

Scenario 1: the investor holds the investment for the full 30 years and pays a 35% tax at the very end. This works out, after taxes, as a return of approximately 13.3% p.a. 

Scenario 2: the investor sells the investment at the end of the year and buys it back. Hence, they pay taxes every year of 35%, which works out as a return of 15% - 35%*15% = 9.75% p.a. 

Munger says, “So, the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods is truly eye-opening. If you sit on your ass for long, long stretches in great companies, you can get a huge edge from nothing but the way taxes work”. 

Summary 

So, there is a huge tax benefit in a buy and hold strategy on a well-diversified portfolio or broad-based ETF which rises over time. By deferring the capital gains tax, it helps the investment to compound, and as Charlie Munger says, “The first rule of compounding is to never interrupt it unnecessarily”. 

There will, of course, still be tax payable by the investor on any dividends and distributions produced by the portfolio or ETF. In the case of ETFs, items such as dividends, interest (if there is cash in the ETF), franking credits, and any capital gains (received from shares sold in a rebalance) are all passed through to the investor. So, taxes do apply, but it’s still a very efficient way to invest. 

One of the reasons we like ETFs is they are tax efficient. The ETFs in our portfolios track a broad based index and ETFs have low portfolio turnover. They incur lower capital gains tax than most actively managed funds which reguarly trade and lead to higher capital gains tax. As with shares if you've owned an ETF for more than 12 months, the taxable capital gains is reduced by 50% for individual investors.

So, there are many benefits of having a long-term well-diversified portfolio. It lowers risk, lowers stress, and lowers the need for investor activity. It also enables the compounding effect, and provides excellent tax benefits and long-term returns.