Taxes: just the word can conjure anxiety, fear, and confusion. I am sometimes surprised by the number of intelligent and successful people I meet with very little tax knowledge. Often when you broach the subject, they say something along the lines of “my tax guy takes care of all that” before they quickly move on. And yet taxes play such a profound role in people’s financial lives, that they demand serious attention and thought in crafting a financial plan and investment strategy. While the immensely wealthy have always had a strong focus, bordering on obsession, on tax minimization, the majority of people do not-to their detriment.
An extreme example of tax minimization is Warren Buffett. In 2016, Buffett reported $11.6 million in gross income, and after $3.5 million in charitable contributions and $5.5 million in deductions, paid $1.8 million in federal income tax. While Buffett’s 16% effective tax rate sounds attractive on the surface, Buffett’s net worth increased by $12 billion in 2016. This bears repeating: Buffett’s net worth grew by $12 billion, and he paid $1.8 million (0.015%) in total federal tax. Why? The $12 billion was comprised almost entirely of unrealized capital gains.
Some initial steps we can take to build tax efficiency into our financial lives:
Step 1: Build your tax IQ, work with a competent tax professional, and maximize your deductions.
The first step is to legally shield as much income as possible. In addition to working with a tax savvy accountant, it is very important for a client to steadily build tax knowledge and sophistication, tax IQ as I call it. This should be seen as a steady accumulation of insights over time, which accrue to a solid working knowledge of taxes. This is analogous to having a rudimentary understanding of the human body, anatomy and medicine. From this more educated perspective, we can ask deeper and more probing questions, and better leverage our doctor’s ability to foster better health outcomes.
Step 2: Maximize contributions to tax-deferred accounts.
Tax-deferred accounts are enormously powerful weapons in the investor’s arsenal. A client should look to maximize the amount of pre-tax income he can put into these accounts. From 401ks and IRAs to Health Savings Accounts and 529 education accounts, clients need to work with their advisor to understand their optimal tax-deferred account options.
Step 3: Adopt an investment strategy that looks to maximize long-term after tax returns.
For a long-term investor, the optimal investment strategy is one that is equity-oriented, with a long holding period, and minimal portfolio turnover. Why equity-oriented? Economist James Poterba of MIT published a study that looked at the tax impact on different asset classes from 1926 to 1996. Here are his findings:
Large stocks: pre-tax return: 12.7% after-tax return: 9.2% tax-burden %: 28%
Treasury bonds: pre tax return: 5.6% after-tax return: 3.4% tax burden %: 38%
Treasury bills: pre-tax return: 3.8% after-tax return: 1.6% tax burden %: 42%
While equities are clearly the highest returning asset class, they also have the lowest percentage tax burden. The result is that equities’ relative return advantage to bonds and t-bills is even greater on an after-tax basis. The lesson: long-term, tax-sensitive investors should have portfolios which are equity-focused.
With an equity-oriented portfolio, the next step is to try and optimize that portfolio to minimize after-tax returns. The best way to achieve this is with a long-term equity portfolio with low turnover. Consider a recent example given by investment management firm Ruane Cunniff.
Two investors: Investor A invests $100,000 in a portfolio with 100% annual turnover (all holdings bought and sold within a year) that returns 7% pre-tax per year for 10 years.
Investor B invests $100,000 in a long-term portfolio with 0% turnover (no sales) until the end of 10, when all the holdings are sold. This portfolio also returns 7% pre-tax per year for 10 years.
Two investors, two very different portfolio styles, with the same pre-tax returns. How did they do on an after tax basis after 10 years? Investor A had all of his yearly gains taxed as short-term capital gains, or ordinary income (we will use 35% in this example). His compounded annual return for the 10 year period: 4.6%, or $156,800.
Investor B’s long holding period, coupled with all the gains being taxed as long term capital gains (20%) at the end of the 10 years, resulted in compounded annual return of 5.9%, or $177,400. Of this 130 basis point return advantage over investor A, fully 100 basis points was attributable to simply avoiding short-term capital gains. The remaining 30 bps resulted from letting unrealized gains compound tax-free for years before finally paying tax.
The final point centers on portfolio management. An investor should concentrate his equity exposure in tax-deferred accounts and bond and cash exposure in taxable ones. I see far too many people with too much cash and liquidity in their IRAs and 401ks and too much equity exposure in their taxable accounts. Think of another tax savvy investor, Mitt Romney and his much publicized $100 million SEP-IRA. How do you amass $100 million in an account where you can contribute at most, say, $30,000 a year? Romney concentrated the highest risk/reward component of his overall investment assets in this IRA, generated remarkable returns, and let these gains compound tax-free for decades. A powerful, if extreme, lesson in tax sophistication.
In conclusion, don’t bury your head in the sand and avoid the topic of taxes. If the only certainties in life are death and taxes, you owe it to yourself to reduce your tax burden and maximize your after tax returns. Dolan Partners can help construct a financial plan and investment strategy, while working collaboratively to build tax sophistication and awareness in clients.