By Scott Francis

May 11, 2012

PORTFOLIO POINT: When it comes to after-tax returns, it’s clear that shares outperform bonds over the longer term.

A great disservice is done to the investment public by the reluctance of the financial services industry to talk in after-tax returns. The majority of fund managers don’t provide investors with data about tax returns, even though we only get to keep the ‘after-tax’ returns from our investments.

When we talk about the performance of different asset classes, it is difficult to find figures about the after-tax returns that we can use to compare asset classes.

To start to rectify this, we will compare the after-tax returns for bonds and shares, and see what the tax difference between the two might be.

A Simulated Example

Let’s start by comparing the difference in returns for both asset classes, if both asset classes provide a reported return of 7% a year over a period of time – say 10 years. Let’s consider the impact of tax on two different investors, one with a 31.5% (30% plus 1.5% Medicare levy) tax rate and the other with a 0% tax rate (superannuation fund paying a pension).

The after-tax bond return is relatively straightforward to calculate. Let’s assume a $10,000 investment in a corporate bond that pays 7% a year, maturing at the end of the 10 years. The $10,000 that is invested will be repaid at the end of the 10 years, and each year $700 in interest repayments will be made to the owner of the bond. This is a pretty straightforward example, although there is the possibility of a bond increasing or decreasing in value, depending on factors such as changes in interest rates. However, in the absence of knowing what these are in advance, it is easiest to assume that the investor buys the bond, receives the interest repayments and then has their investment ($10,000) repaid at the end of the 10 years.

For the investor on the 0% tax bracket, the calculation is straightforward – they pay no tax and so receive an after-tax return of $700 a year; a total investment return of 7% p.a.

For the investor on the 31.5% tax bracket, we have to get the calculator out. The $700 a year that they receive is taxable at the rate of 31.5%, which means they pay tax of $220.50. Their return after tax is $479.50 a year, or 4.8% p.a.

Now let us consider an investment in a share (or portfolio of shares) over the same period. Again, the return will be 7%, made up of an average return of 4.5% a year in fully-franked dividends, and 2.5% a year capital growth.

For the investor on the 0% tax bracket, the calculation is slightly more complex. They will receive $450 a year in income, plus franking credits of $193. For an investor on a 0% tax rate (e.g. a superannuation fund paying a pension), this $193 is received back as a tax refund, so the income benefit that an investor receives is $450 + $193 = $643.

On top of this are a further 2.5% a year ($250) of capital growth. We will assume that the shares are sold at the end of the 10 years, but an investor on the 0% tax bracket will have no capital gains tax to pay.

So to recap, the investor on a 0% tax rate will receive an average annual return of $643 in income ($450 cash and $193 tax refund), and $250 a year in capital gains – a total return of $893 a year, or 8.9%.

Now, to the investor on the 31.5% tax rate: They will also receive income and tax credits of $643 a year, and will have to pay tax on this amount at the rate of 31.5% – a total liability of $202. After tax, they will receive annual income of $441.

They will also have to pay tax on the capital gains in their portfolio at the end of the 10 years. Capital gains of $250 a year over 10 years will total $2,500 in gains. As these are long-term capital gains – because the investment has been in place for 10 years – they will have 50% of their gain taxed at 31.5%. This means they will lose $394 of the capital gain to capital gains tax. This is equivalent to $40 a year and reduces the benefit of the capital gain from $250 a year to $210.

So for a person on a 31.5% tax rate, they receive (after tax) $441 a year in income and $210 in capital gain – a total return of $651 a year, or 6.51% a year.

-Simulated After-Tax Returns – Shares and Bonds

It is interesting to look and see if these simulated returns have any value in real life. Many index fund managers do report after-tax returns – they tend to be more tax-effective than ‘active’ investment strategies and it is to their advantage to report after tax. Over the past eight years (to the end of March 2012), the Vanguard Index Diversified Bond Fund (6.50% p.a.) and the Vanguard Index Australian Share Fund (6.94% p.a.) have had similar pre-tax returns. However, after tax at the 31.5% rate, the share fund provides a return that is 2% a year higher.

In real life, this means an investor on the 31.5% tax rate will have seen a $100,000 investment in the bond index fund grow from $100,000 to $143,500. In the share index fund, the $100,000 would have grown from $100,000 to $167,000.

For an investor on a 0% tax rate (e.g. a superannuation fund in pension mode), the bond fund investment would have grown from $100,000 to $165,500. The share fund investment would have grown from $100,000 to $188,500.

-Real Life Returns – Vanguard Index Funds

Conclusion

The bottom line is that tax matters. In the Australian context, there is not enough data about after-tax returns, either from fund managers or generally on asset classes. Following the global financial crisis, the unattractive element of shares – their volatility – is well known. However, their tax effectiveness, due to the franking credits often paid with dividends, should be kept in mind. Of course, investors are likely to include some shares and bonds in their portfolio, and will therefore enjoy the benefits of both!