Taxes & Tax Planning

11/21/06 - Taxes: The Natural Enemy of Investors

By: Frank Armstrong, CFP, AIFA

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 35%, and long-term capital gains at 15%.

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 15%, so his net accumulation is $1,498,199. 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 15% long-term capital gains rate is applied) is $149,816. 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 35%, and the remaining after-tax accumulation has shrunk to $1,069,211. 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 35%. So, he will net $113,421. 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 8.5% per year, and the accumulation is $1,155,825.

Because he paid taxes on gains all along, the net sum after liquidation is also $1,155,825. The boat budget is about the same as for case 2.

Otherwise, our investor's annual income on his remaining $1,155,825 would be $115,582, netting $98,245 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 6.5%, because 35% of each year's gain is taxed away; over the years he has to cough up $280,679 for Uncle Sam. Gross accumulation is $661,436.

Because he has paid taxes on all appreciation already, the net amount after liquidation is the same, $661,436. 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 $42,993 after income taxes are paid at the 35% rate. The smaller accumulation and the larger annual tax bite are devastating. Darling, pass me a Budweiser.

Sizing up the Strategies
Case	Strategy	Pre tax Accumulation	Post tax Accumulation	Annual Post tax Income
1	Deferred long-term gains	$1,744,940	$1,498,199	$149,816
2	Deferred ordinary income	$1,744,940	$1,069,211	$113,421
3	Annual realized long-term gains	-	$1,155,825	$98,245
4	Annual ordinary income	-	$661,436	$42,993
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.

**This article was previously published a few years ago, but was updated to reflect the revised tax code.**

Death and taxes may be inevitable, but taxes are manageable.

Ask your financial advisor how he or she is helping you manage taxes.