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Is this hidden force destroying your investment returns?

There are a few different things that can really hurt your overall investment returns, some of them are hidden.

We all know that choosing a poor-performing investment can lead to bad returns. Long-term investors in shares like AMP Limited (ASX: AMP) and Myer Holdings Ltd (ASX: MYR) have seen a lot of value destruction.

Over the past decade a lot of investors have come to terms with the fact that fees and brokerage can be a big detriment to returns. There’s a reason why Warren Buffett bet that a low cost S&P 500 index fund would outperform some hedge funds. Mr Buffett won that bet.

But there’s another drain on returns:

Tax 

Don’t worry, I’m not about to suggest you shift your tax status to Monaco, the Cayman Islands, Lichtenstein or the Bahamas.

How much you are taxed on your investment returns can make a big difference to the end total in a few decades. There’s a reason why superannuation is seen as such an attractive method for building wealth, the taxes are lower.

Imagine if you were quite active in your investment changes, didn’t hold any investment for longer than 12 months and you made a 10% net return before taxes during a tax year. That’s not a bad result.

But perhaps all of those investment returns were subject to tax because you crystallised your capital gains so often and so quickly. Not only did you miss out on the 12-month, 50% capital gains discount, but depending on your tax rate you may have to pay a third or perhaps almost a half of your gains to the tax office. Now your after-tax return is only around 6.6%, or maybe a little lower.

Imagine instead if you owned shares like Xero Limited (ASX: XRO) or A2 Milk Company Ltd (ASX: A2M) for the whole year, made a 10% and didn’t sell. No taxes. It was the same net return before taxes, but after tax there’s a big difference.

I think tax is an important component of thinking about investments. You need to think about the after tax return.

High dividend yields can also have a similar effect. If your investment pays out most of its profit as dividends like National Australia Bank Ltd (ASX: NAB) or Westpac Banking Corp (ASX: WBC) then a lot of your returns could be eaten up by tax unless you’re in a low tax rate or in retirement, or the investment is in superannuation.

Foolish takeaway

Growth shares have a number of advantages. Taxation is one of the main factors that can play a big difference over the long-term.

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Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia owns shares of A2 Milk, National Australia Bank Limited, and Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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