1. Taxes and Investment Performance

2. Comparison of Highest and Lowest Marginal Tax Rates 1926–2013
• Highest rate
• Lowest rate 80 60 40
Comparison of Highest and Lowest Marginal Tax Rates
Marginal income tax rates and the number of brackets have varied greatly over time.
The United States income tax system, as we know it, was enacted in Early on, only very high income individuals had to pay income tax. The image compares the highest and lowest marginal rates from 1926 to The highest marginal rate exceeded 90% during both World War II and the Korean War, while the lowest marginal rate rarely exceeded 20%.
Overall, tax rates over the past 20 years were lower than they had been historically, particularly for higher income individuals. However, the top tax bracket has increased recently as per the American Taxpayer Relief Act of 2012.
Source: Pechman, Joseph A., Federal Tax Policy, fifth edition, The Brookings Institute, 1987; Standard Federal Tax Reports, CCH; Federal Individual Income Tax Rates History, Tax Policy Center, Historical Top Tax Rate, 20
1926
1936
1946
1956
1966
1976
1986
1996
2006
© 2014 Morningstar. All Rights Reserved.

3. Ibbotson® SBBI® Stocks, Bonds, Bills, and Inflation 1926–2013
$26,641
Compound annual return
10k
• Small stocks
12.3 %
$4,677
• Large stocks
10.1
• Government bonds
5.5
• Treasury bills
3.5 1k
• Inflation
3.0
$109
100
Ibbotson® SBBI® 1926–2013
An 88-year examination of past capital market returns provides historical insight into the performance characteristics of various asset classes. This graph illustrates the hypothetical growth of inflation and a $1 investment in four traditional asset classes over the time period January 1, 1926, through December 31, 2013.
Large and small stocks have provided the highest returns and largest increase in wealth over the past 88 years. As illustrated in the image, fixed-income investments provided only a fraction of the growth provided by stocks. However, the higher returns achieved by stocks are associated with much greater risk, which can be identified by the volatility or fluctuation of the graph lines.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes. Furthermore, small stocks are more volatile than large stocks, are subject to significant price fluctuations and business risks, and are thinly traded.
About the data
Small stocks in this example are represented by the Ibbotson® Small Company Stock Index. Large stocks are represented by the Standard & Poor’s 90 Index from 1926 through February 1957 and the S&P 500® Index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Government bonds are represented by the 20-year U.S. government bond, Treasury bills by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. Underlying data is from the Stocks, Bonds, Bills, and Inflation® (SBBI®) Yearbook, by Roger G. Ibbotson and Rex Sinquefield, updated annually. An investment cannot be made directly in an index.
$21
$13 10 1
0.10
1926
1936
1946
1956
1966
1976
1986
1996
2006
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2014 Morningstar. All Rights Reserved.

4. Ibbotson® SBBI® After Taxes 1926–2013
$933.74
$1,000
Compound annual return
• Stocks
8.1%
• Municipal bonds
4.4
• Government bonds
3.4
• Inflation
3.0
100
• Treasury bills
2.2
$43.55
$18.46
$13.02 10
$6.66
Ibbotson® SBBI® After Taxes 1926–2013
Taxes can have a dramatic effect on an investment portfolio. Stocks are one of the few asset classes that have provided significant after-tax growth over time. This image illustrates the hypothetical growth of inflation and a $1 investment in stocks, municipal bonds, government bonds, and Treasury bills after taxes over the time period January 1, 1926, through December 31, 2013.
Over the long run, the adverse effect of taxes on investment returns becomes especially pronounced. Stocks are the only asset class depicted that provided any significant long-term growth. After considering taxes, government bonds barely outperformed inflation over this time period. Municipal bonds (for which income is exempt from federal income taxes) outperformed government bonds but significantly underperformed stocks. In a world with taxes, focusing on fixed-income assets alone has not provided investors with a substantial increase in wealth.
If you desire substantial after-tax growth, you may want to consider a larger allocation to stocks. Another alternative, if you are able, is to consider tax-deferred investment vehicles.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and municipal bonds are not guaranteed. Stocks have been more volatile than the other asset classes. Municipal bonds may be subject to the alternative minimum tax (AMT) and state or local taxes, and federal taxes would apply to any capital gains distributions.
About the data
Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No capital gains taxes on municipal bonds are assumed. No state income taxes are included.
Stocks are represented by the Standard & Poor’s 90 index from 1926 through February 1957 and the S&P 500® index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Municipal bonds are represented by 20-year prime issues from Salomon Brothers’ Analytical Record of Yields and Yield Spreads for 1926–1985 and Mergent’s Bond Record thereafter. Government bonds are represented by the 20-year U.S. government bond, inflation by the Consumer Price Index, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index. 1
0.10
1926
1936
1946
1956
1966
1976
1986
1996
2006
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926, with taxes paid monthly. No capital gains taxes are assumed for municipal bonds. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Assumes reinvestment of income and no transaction costs. © 2014 Morningstar. All Rights Reserved.

5. Ibbotson® SBBI® After Taxes and Inflation 1926–2013
$100
$71.72
Compound annual return
• Stocks
5.0%
• Municipal bonds
1.4
• Government bonds
0.4
• Treasury bills
–0.8 10
$3.34
Ibbotson® SBBI® After Taxes and Inflation 1926–2013
The adverse effects of inflation and taxes on investment returns become especially pronounced over the long run. This image illustrates the hypothetical growth of a $1 investment after considering the effects of both taxes and inflation on each asset class over the past 88 years.
Of the asset classes considered, stocks are the only asset class that provided significant growth. Municipal bonds, for which income is exempt from federal income taxes, barely provided enough total return to offset inflation. Government bonds closely kept pace with inflation. Treasury bills, however, fared the worst. After considering both taxes and inflation, the initial $1 was reduced to approximately $0.51.
If you wish to overcome the effects of taxes and inflation, you may want to consider a larger allocation to stocks. Another alternative, if you are able, is to consider tax-deferred investment vehicles.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and municipal bonds are not guaranteed. Stocks have been more volatile than the other asset classes. Municipal bonds may be subject to the alternative minimum tax (AMT) and state or local taxes, and federal taxes would apply to any capital gains distributions.
About the data
Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No capital gains taxes on municipal bonds are assumed. No state income taxes are included.
Stocks are represented by the Standard & Poor’s 90 index from 1926 through February 1957 and the S&P 500® index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Municipal bonds are represented by 20-year prime issues from Salomon Brothers’ Analytical Record of Yields and Yield Spreads for 1926–1985 and Mergent’s Bond Record thereafter. Government bonds are represented by the 20-year U.S. government bond, inflation by the Consumer Price Index, and Treasury bills by the 30-day U.S. Treasury bill. An investment cannot be made directly in an index.
$1.42 1
$0.51
0.10
1926
1936
1946
1956
1966
1976
1986
1996
2006
Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926, with taxes paid monthly. No capital gains taxes are assumed for municipal bonds. Assumes reinvestment of income and no transaction costs. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2014 Morningstar. All Rights Reserved.

6. Taxes Significantly Reduce Returns 1926–2013
10%
10.1% 8
8.1% 6
5.5% 4
Taxes Significantly Reduce Returns
Intuitively, you know that taxes reduce the earnings you retain. This image illustrates how much the federal government withheld from one hypothetical investor following a simple long-term investment strategy.
Stocks after taxes assumes that the stocks purchased were held for five years, then sold, and the capital gains realized. The net proceeds from the sale were reinvested. Dividends were taxed when earned and reinvested. From 1926 to 2013, the average return on stocks after taxes was 8.1%, compared with 10.1% before taxes.
Bonds were turned over 28 times within the 88-year period. Capital gains were realized at the time of sale and reinvested. Bonds averaged a 3.4% return after taxes, compared with 5.5% before taxes. After taxes, on average, bonds barely outpaced the inflation rate.
Cash earned an average of 2.2% after taxes, compared with 3.5% before taxes, over this time period. Comparing the after-tax return to the rate of inflation, you can see that if you invested solely in cash equivalents, you actually lost money in terms of purchasing power.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes.
About the data
Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included.
Stocks are represented by the Standard & Poor’s 90 index from 1926 through February 1957 and the S&P 500® index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Government bonds are represented by the 20-year U.S. government bond, cash by the 30-day U.S. Treasury bill, and inflation by the Consumer Price Index. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for transaction costs.
3.4%
3.5%
3.0%
2.2% 2
Stocks
Stocks after
Bonds
Bonds after
Cash
Cash after
Inflation
taxes
taxes
taxes
Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2014 Morningstar. All Rights Reserved.

7. Lower Capital Gains Taxes Have Benefited Stocks in Recent Years Spread between before- and after-tax returns over various holding periods
4% Return spread
3.93%
• Stocks
• Bonds
3.24% 3
2.88% 2
1.76%
Lower Capital Gains Taxes Have Benefited Stocks in Recent Years
In recent years, capital gains tax rates have been significantly lower than most marginal tax rates. Until 2012, the capital gains rate was 15% for investors in the 25%, 28%, 33%, and 35% marginal tax brackets and 0% for those in the 10% and 15% brackets (tax rates from the Tax Foundation, taxfoundation.org). In 2013, following the American Taxpayer Relief Act of 2012, a higher capital gains tax rate of 20% applied to investors in the 39.6% bracket. The current tax treatment has generally benefited stocks because the primary purpose for investing in them is capital appreciation. Income payments in the form of dividends are generally secondary and make up a much smaller portion of a stock’s total return. Historically, dividends were taxed at marginal income tax rates, though since 2003 dividends on qualified investments have also received favorable tax treatment.
Conversely, bonds are predominantly an income-producing investment with low to moderate levels of capital appreciation. As such, the income received from coupon payments is taxed at an investor’s marginal income tax rate. Since marginal tax rates are higher than capital gains rates, bond investments generally have been taxed more heavily than stocks over the time periods illustrated.
While taxes are an important consideration in the investment process, it is important to keep in mind that returns and principal invested in stocks are not guaranteed and that stocks have been much more volatile than bonds historically.
Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than other asset classes.
About the data
Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $110,000 in 2010 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included.
Stocks are represented by the Standard & Poor’s 90 index from 1926 through February 1957 and the S&P 500® index thereafter, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. Bonds are represented by the 20-year U.S. government bond. An investment cannot be made directly in an index. The data assumes reinvestment of income and does not account for transaction costs. 1
0.49%
0.37%
0.39%
0.33%
3-year
5-year
10-year
20-year
Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2014 Morningstar. All Rights Reserved.

8. Benefits of Deferring Taxes
$250k
• Value of taxable account
• Value of tax-deferred account
200
150
100
Benefits of Deferring Taxes
While it is impossible for individuals to avoid taxes with most investments, it is often possible to defer taxes. Deferring taxes over long periods of time can result in potential gains.
When holding investments subject to taxation, it is possible to defer taxes by delaying the sale of the investment (not realizing the gain). However, taxes on income, such as coupons or dividends, must be paid annually.
The impact of taxes on an investment portfolio can be reduced through the use of tax-deferred investment vehicles. Examples include individual retirement accounts (IRAs), company-sponsored 401(k) plans, 403(b) plans, Keogh plans, and tax-deferred annuities. Talk to a professional investment advisor to learn more about the differences between these tax-deferred investment vehicles and to your employer to learn about plans sponsored by them. Tax-deferred vehicles work by allowing interest, dividends, and capital gains to accumulate without incurring taxes. Taxes are due only when withdrawals from the plan begin.
This image illustrates how deferring taxes can increase the value of an investment over time. A hypothetical value of $10,000 is invested in both a taxable and a tax-deferred account. The difference is fairly modest after 20 years. After several more years, however, the difference is more substantial. Allowing the investment to grow tax-deferred for 35 years would have provided approximately $9,256 more than the taxable account. After 45 years, the difference is even more dramatic.
Returns and principal invested in stocks are not guaranteed. Deferred investment accounts, such as IRAs, 401(k)s, and annuities, are long-term tax-deferred investment vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
Changes in tax rates and tax treatment of investment earnings may impact comparative results. Investors should consider their personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision, as these may further impact the results of the comparison.
About the data
This hypothetical example is for an investor in the 28% bracket using the 2014 tax code (established by the American Taxpayer Relief Act of 2012). $10,000 is invested in stocks at the beginning of year 1 (2014). Assumes an 8% annual total return (6% price return and 2% income return) and a 15% tax rate on capital gains and dividends. The data assumes reinvestment of capital gains and dividends and does not account for transaction costs. Taxes are assessed yearly on the taxable account but only at the end of the period on the tax-deferred account. Estimates are not guaranteed. 50
5 years 10 15 20 25 30 35 40 45
to retirement
Hypothetical value of $10,000 invested in stocks. This example is for an investor in the 28% bracket using the 2014 tax code. Assumes an 8% annual total return. Estimates are not guaranteed. This is for illustrative purposes only and not indicative of any investment. © 2014 Morningstar. All Rights Reserved.