Session 8. Making The Most After Taxes

Taxation is a very complicated topic.  See a good professional tax advisor if you want to do anything complicated or remotely akin to a "tax shelter."

At the simpler end of the spectrum, most "how-to" books and articles on financial planning will encourage you to use tax-deductible home equity loans, avoid taking short-term gains on stocks, buy municipal bonds if you are in the top tax bracket and want bonds, use Section 529 plans for saving for your children's education, and so on.  In contrast, what we'll focus on here is the benefit of enlarging the fraction of your assets that represents unrealized capital gains -- the profits on securities you have not sold.

As a first approximation, not paying capital gains taxes now on your unrealized gains is like an interest-free loan from the government.  However, it is considerably more flexible than most loans -- its size goes up and down with your net unrealized gains (after subtracting unrealized losses), and you can pay it off with no penalty at any time.  It is actually more like a partnership -- the government gets its share of any profits you earn based on the additional capital.

How do you increase the size of this asset that you can deploy for profit-making without the added risk and interest expense of true debt?  A good first principle is to give your unrealized gains time to grow.  You can do this by keeping trading activity very low, less than 10% a year, and 5% is much better.  For most of us, the most effective way of doing this while remaining well-diversified is with index mutual funds or the newer ETF's.  This strategy will not pay off much in the first five years of holding stocks.  However, its rate of payoff gradually increases, asymptotically approaching the capital gains tax rate times the average rate of price increase.

What would you say to a strategy that could double that part of your retirement wealth derived from taxable investments?  That is not implausible as compared to the results of active investment managers with average skill (none) and 100% annual turnover.  If we count the likely improvement through avoidance of trading costs, the comparison would be even more lop-sided.

The chart below compares a buy and hold strategy over 40 years, liquidating and paying capital gains taxes only at the end, with an active management strategy with the same pretax return and 100% annual turnover of the securities in the portfolio.  The assumptions are 10% constant pre-tax return and a 23% combined US federal and state capital gains tax rate.  If you start at age 30 and liquidate at age 70, you come pretty close to doubling the wealth attained through an active investment policy with the same pre-tax return.  The effective capital gains tax rate has been cut from 23% to about 10%!  On the other hand, if you give up and trade after only the first five years, implying an annual turnover rate of 20%, the benefit is negligible.

Even index funds have some turnover as companies fall in and out of the index.  In practice, it is sometimes very useful to sell stock equity -- to diversify a holding grown to be too large, say 10% or more of your portfolio, or to otherwise reduce risk if you would otherwise take too big a chance of a critical shortfall.  If you have a large portfolio with many relatively small holdings of different stocks, it may be possible to take advantage of such opportunities to maintain diversification or adjust overall risk levels even while growing unrealized gains even faster than a low-turnover index fund.  That is, you can approach the asymptotic limit on extra after-tax return at an earlier stage.  A more sophisticated policy than simple buy-and-hold is selective selling.  If you keep track of separate tax lots you can get more from this approach.

This is done by taking advantage of the tax benefits of focusing whatever turnover needs you have on those investments with the biggest unrealized losses, and after that, with the smallest unrealized gains.  (More generally, taking into account higher short-term capital gains tax rates, sell the tax lot with the least tax penalty or the most tax benefit first.)  Realizing losses is a policy quite contrary to human nature -- which hates to admit a mistaken purchase.

Some mutual fund companies are now permitting you to specify which tax-lot you wish to sell if you have made multiple purchases of  a particular fund.  This allows you to sell the one with the highest purchase cost and so maximize the buildup of your unrealized capital gain -- a very worthwhile option, though not quite as valuable as being able to select sales among different stocks.

The key concept for better after-tax returns is not so much to take advantage of loopholes, but simply to make use of the government's implicit subsidy of long-term investment policies. Keep turnover low, and when you do trade, always keep the similar security or tax lot with the lowest cost as a percentage of its current price.

[Next Session]