Via Monte Carlo simulation analysis that uses historical U.S. stock market returns, we assess the total investment income tax burden (federal plus state, including time value of money) of active portfolio management. Our results show that taxes can erode a large portion of the profits, even for moderately intense trading strategies where the capital gains qualify for long-term treatment. Additionally, we calculate pre-tax alphas necessary to overcome the “tax penalty” for various active strategies. We find that under average market conditions, active portfolio management erodes up to 9.89% to 13.36% of profits for high-income individuals, depending on the tax law and assumptions about realized losses. Active strategies must generate an alpha of up to 0.73% to 0.96% per year just to overcome the tax obligations arising from realized gains. The consequences of active management are substantially milder for low-income individuals due to the lower tax rates on dividends and long-term capital gains.
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