This month marks the 50th anniversary of the inception of the first stock index fund.
Among the effects of index funds was to increase the focus of investors on fees and expenses.
Reducing fees and expenses is a good way to increase net investment returns.
But the focus on fees and expenses also diverted the attention of investors.
Fees and expenses have become the main focus of many investors, causing them to lose sight of more significant leakages from their investment returns.
Most investors do not realize that federal income taxes take a much larger chunk out of their net investment returns than other factors.
Neglecting tax reduction strategies can substantially reduce lifetime net investment returns.
This point was demonstrated in a recent study by Andrew Ang of BlackRock.
The study estimated both the investment returns and taxes imposed on a hypothetical investor who held a market portfolio from 1926 to 2025.
The estimate of the tax cost incorporated the many changes that were made to the tax code over time.
The study found that substantial taxes were imposed on the investments a taxable account during the period.
Federal taxes reduced the long-term equity wealth by more than one-third. States taxes reduced the returns further for most investors, though state taxes were not part of the study.
The study also computed the pre-tax and after-tax returns for overlapping 30-year periods and found that the tax drag varied over time.
Taxes reduced the average annual return by 3.47% over the full period.
Taxes were the most burdensome from 1936-1965, reducing average annual returns by 5.38%.
From 1996-2025, taxes took only 1.65% of returns, the lowest amount during the study. That probably was because of the introduction of a lower tax rate on qualified dividends.
The study found that taxes on dividends accounted for the dominant share of taxes paid on investment returns, making the tax reduction on qualified dividends very important for investors.
The study assumed the investor was a buy-and-hold investor, which minimized sales and thereby reduced taxes on capital gains.
Most investors buy and sell stocks more frequently than assumed in the study. Because of that, the study probably underestimated the taxes an average investor would have paid.
In addition, the study recognized that capital gains taxes on appreciation would be eliminated when an investor held the portfolio until death.
Heirs are allowed to increase the tax basis of inherited investments to their current fair market value. Heirs can sell at prevailing prices and not owe taxes on any of the appreciation that occurred during the previous owner’s lifetime.
The study reviewed only taxes on investments held in taxable accounts.
But investors in tax-deferred accounts, such as traditional IRAs and 401(k)s, are not off the hook.
They owe no taxes while investments remain in the accounts. But the money is fully taxed when it is distributed.
In fact, tax-deferred investors might owe more lifetime taxes than investors in taxable accounts, because distributions from traditional IRAs and 401(k)s are taxed as ordinary income.
Those investors do not receive the benefit of lower tax rates on qualified dividends and long-term capital gains. Their heirs also must pay taxes on distributions from the accounts, just as the original owner would have.
The study demonstrates that it is important for investors who want to increase their after-tax wealth and make retirement savings last longer need to engage in lifetime tax reduction strategies.
