Tim- a nice article ...Taxes: The Natural Enemy of the Investor
by Frank Armstrong | Everybody knows that taxes are a drag on
performance, but I am constantly surprised at the number of investors
that blithely pay taxes each year on their investment earnings without
considering the impact on accumulation or the alternative strategies
that they could employ.
It's never a good idea to let the tail wag the dog, of course--a rational
investor shouldn't seek tax avoidance, or tax minimization per se. But
it makes sense to pursue the highest after-tax return.
Building a Tax Model
Let's build a simple model to examine the impact of taxation, which
varies with tax rates and the length of deferral. Our investor has a
lump sum of $100,000 to invest for 30 years, after which he either
liquidates the accumulation to buy a yacht or keeps the capital intact
and uses annual income or gains to finance his retirement. Assume his
investments have a nominal (before tax) annual return of 10%.
We will deduct federal taxes from the account as income is distributed
or gains are realized. We will also assume that the investor's marginal
tax rate is the account's effective rate (which would not be true for an
investor who had little or no other income). Income and short-term
gains will be taxed at 39.6%, and long-term capital gains at 20%.
Case 1: Deferred long-term gains
In this case, our investor could buy and hold shares of stock that do
not pay dividends. The effective tax rate on unrealized gains would be
zero. At the end of 30 years, his investment would have grown to
$1,744,940, and he will not have paid a penny of tax. (If our investor
dies now or anywhere along the way, income tax, though not estate
tax, is forgiven, and he will never have paid any tax on the gains. A
moral victory, at least.)
If he sells his entire account at this point to buy a boat, his gain of
$1,644,940 is taxed at 20%, so his net accumulation is $1,315,952.
That would purchase a new luxury 60-foot trawler with
intercontinental range.
By instead selling appreciated shares equal to the annual return of
10%, our investor grosses $174,494 annually. Assuming his
investment was for 10,000 shares at $10 per share, each share is now
worth $174.49. He must sell 1,000 shares his first year and after
adjusting for basis his profit per share is $164.49. So his net annual
income (after the 20% long-term capital gains rate is applied) is
$141,595. Darling, ask Jeeves to break out the Dom!
Case 2: Deferred ordinary income
Here our investor finds an inspired manager who can overcome the
enormous internal costs of a variable annuity (VA), so he earns returns
at the same 10% rate before tax as in the first case. There are no
annual tax bills, so the gross accumulation is also $1,744,940.
If the account is liquidated as a lump sum, all but the original
$100,000 is taxed as ordinary income at 39.6%, and the remaining
after-tax accumulation has shrunk to $993,543. A well-maintained
10-year-old cruiser in the 55-foot class isn't out of the question.
Alternatively, our investor has a gross annual income of $174,494,
which is reduced by the ordinary income-tax rate of 39.6%. So, he
will net $105,394. The higher tax rate on withdrawal bites into
income, but there is plenty left thanks to the deferral. Darling, shall I
get you some champagne?
Case 3: Annual realized long-term gains
In this case our investor purchases a mutual fund or managed account
that has high annual turnover. Say the fund generates no interest,
dividends, or short-term gains. The effective turnover is 100%, and all
gains are realized and taxed each year. The investment account thus
compounds at just 8% per year, and the accumulation is $1,006,266.
Because he paid taxes on gains all along, the net sum after liquidation
is also $1,006,266. The boat budget is about the same as for case 2.
Otherwise, our investor's annual income on his remaining $1,006,266
would be $100,627, netting $80,502 after long-term gains taxes. The
annual tax during the accumulation period reduced the pie available to
convert to retirement income. Darling, where's that bottle of wine
we've been saving?
Case 4: Annual ordinary income
Finally, the investor might opt for a fully taxable investment that
generates its entire return in taxable income or short-term realized
gains. (An extremely high-turnover mutual fund might produce the
latter scenario.) The effective compounding rate is only 6.04%,
because 39.6% of each year's gain is taxed away; over the years he
has to cough up $315,283 for Uncle Sam. Gross accumulation is
$580,887.
Because he has paid taxes on all appreciation already, the net amount
after liquidation is the same, $580,887. A nice used boat is still a
possibility, but a galley chef is out of the question.
The net annual yield from this investment will be $35,085 after income
taxes are paid at the 39.6% rate. The smaller accumulation and the
larger annual tax bite are devastating. Darling, pass me a Pabst.
Sizing up the Strategies
Pre-tax
Accumulation
Post-tax
Accumulation
Annual
Post-tax Income
Deferred long-term gains
$1,744,940
$1,315,952
$141,595
Deferred ordinary income
$1,744,940
$993,543
$105,394
Ann realized long-term gains
—
$1,006,266
$80,502
Ann ordinary income
—
$580,887
$35,085
Investors should favor long-term deferrals and capital gains treatment, as in the first
case above.
Conclusion
Our model isn't real-world perfect, but it shows that taxes matter--a
lot. Investors should favor long-term deferrals and capital gains
treatment. The closer your portfolio can get to case 1, the more
money you will accumulate.
Even if you don't buy into the efficient-market hypothesis, you may
want to consider index funds for your taxable equity investments.
Actively managed funds generate higher turnover than index funds,
which can lead to bigger tax bills. A new generation of tax-managed
index funds (including three from Vanguard) are somewhat actively
managed in order to control taxes: Hold periods are increased so that
most gains are long term, highest-cost lots are always sold first, and
losses are "harvested" occasionally to offset realized gains.
Death and taxes may be inevitable, but taxes are manageable.
P o s t e d 0 3 - 1 8 - 9 9
Copyright 1999 Frank Armstrong. Frank Armstrong is author of
Investment Strategies for the 21st Century,and president of
Managed Account Services, Inc,a fee-only advisor specializing in
global asset allocation strategies utilizing no-load mutual funds.
Frank is a Certified Financial Planner (CFP) with 25 years'
experience helping investors build wealth.
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