Taxes take a good bite out of the investment returns when added into the total return equation. Let’s consider the largest index fund returns for the last 10 years to make a point.
The vanguard 500 index fund (Symbol: VFINX) is the largest index fund and it is also extremely tax efficient. The 10 year before tax annualized return is 9% currently. Vanguard reports that the returns after taxes on distributions was 8.44% annualized for the last 10 years. And here comes the kicker, returns after taxes on distributions and sale of fund shares was 7.67% annualized for the last 10 years.
Now, I am going to add inflation to the equation. I would like to use 4% annual inflation rate instead of the government reported 3% rate because there is a widespread belief in the sane investment community that the real inflation is close to 4%, if not higher.
Subtract 4% from the 7.67% and you are left with 3.67% real return from your index fund investment. Even if you use the government reported data and subtract only 3% for inflation, the real return stands at 4.67%.
Most of the money invested today does not go to the index funds. Actively managed funds are in business and collectively tend to lag the market by 2%. Those funds leave investors with zero to close to zero gain when Uncle Sam collects and inflation takes its toll.