After-Tax Returns on Stocks Versus Bonds for the High Tax Bracket Investor

Abstract

The notion that stocks outperform bonds over the long run is a widely accepted principle of basic investing. This conclusion may not be as applicable, however, to a high tax bracket investor as it would be to a tax-exempt portfolio. Ibbotson Associates reports that between 1925 and 2004, the annualized compounded return on stocks (represented by the S&P 500) was 10.4% compared to the return on government bonds at 5.4%. The gross return on equities was nearly double the gross return on bonds. “Stocks for the Long Run,” written by Wharton professor Jeremy Siegel, also concluded that stocks have proven to be better investments than bonds over the long run. It is difficult to argue with Siegel's conclusion if one is a non-taxable investor such as a pension, endowment, or even for the average American's 401(k) account. However, does this advice apply to the wealthy family who pays taxes on investment income and capital gains at the highest rates? The article shows the annualized after-tax portfolio return to be 6.72% and the difference between the returns on equities and bonds to be only 58 basis points. And, in the most extreme scenarios, equities may have equaled or underperformed bonds on an after-tax basis.

TOPICS: Security analysis and valuation, fixed income and structured finance, portfolio construction, performance measurement