Executive Summary
- The impact of taxes on your bottom line investing returns is massive, especially for those with a long time horizon.
- Tax efficient investing is not about taking excess risks or implementing legally dubious “schemes.”
- Rather, the goal is to take full advantage of incentives created by the government that allow investors to legally reduce their tax liabilities.
I am always amazed by the defeatist attitude that many investors have towards taxes. Every year, Americans leave billions of dollars on the table because they fail to do some basic “blocking and tackling” that would dramatically enhance the tax efficiency of their portfolios.
This defeatist attitude — and the general unwillingness to implement these strategies — persists for three reasons:
- The Exclusivity Myth: The belief that tax savings strategies are reserved for the ultra-wealthy, who have access to teams of accountants and lawyers at their disposal.
- The Risk Myth: The myth that any strategy that reduces your tax liability is dubious and possibly illegitimate, and that implementing it risks an audit, fine, or jail.
- The Impact Myth: The myth that implementing tax efficient investing strategies barely “moves the needle,” and the payoff doesn’t justify the work or complexity involved to execute.
I’ll tackle the first two points above in the next chapter. Right now, however, I want to tackle this misconception about the impact of taxes on a portfolio.
I’m going to share two hypothetical scenarios that I think are pretty illuminating.
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The Magic Penny
This first example ventures into the realm of fantasy, but the math behind it is very real.
Imagine that you’ve been gifted a magic penny that will double in value every day for a month.
So, on day two your penny doubles to two cents. On the third day, it doubles again to four cents.
And so on, for 31 days.
At the end of the month, you’d have about $10.7 million:
Now imagine a slight twist to this scenario.
The penny still doubles every day for a month, but then you have to pay taxes on the gains at a rate of 35%.
So, on day two… your penny doubles to two cents. Then you have to pay a 35% tax on the gain ($0.01) for that day.
The next day, whatever is left over after paying the tax will double again. And that gain will be taxed again.
Let’s take a look at how the introduction of taxes impacts your wealth creation:
After a month, this version of the Magic Penny has grown to a little more than $33,000. That’s a massive increase from the starting point of $0.01.
It’s also about 0.3% of what you had in the first scenario where there were no taxes.
Or put another way…
Taxes destroyed about 99.7% of your wealth in this example.
Dive into the data behind this example. Click here to open the underlying calculations in a Google Sheet. You can save as an Excel file or to your personal Google Drive.
I love this example because it illustrates the devastating impact of taxes on an investment portfolio. Specifically, it highlights the two ways that taxes destroy wealth:
The Direct Impact
The obvious wealth destruction of taxes comes from the “direct” cost: each dollar that you pay in taxes is one less dollar that you have in your portfolio.
The Indirect Impact
Even more substantial, however, is the “indirect” cost of taxes. Each dollar that you pay in taxes is one less dollar that can be invested in the future, thus reducing your expectations for future dividends and capital gains.
The “Magic Penny” is powerful, but of course not all that realistic. To drive home the impact of taxes on your portfolio, let’s consider a more realistic illustration.
A "Real World" Illustration: Bill & Ted
Consider two nearly identical young professionals, Bill and Ted.
Both are starting their careers at age 22 with relatively high salaries – $100,000 – that will grow at 4% annually throughout their 20s.
Both have nice lifestyles: $60,000 spent annually on rent, food, travel, entertainment, and other expenses, with this amount growing at 4% annually throughout their 20s.
Both pay their taxes on time.
Both do something very admirable and wise (that most 20-somethings don’t): they diligently save everything that’s left over after taxes and expenses.
Their investment strategies are identical: a moderately risky portfolio of stocks and bonds that returns 8% a year.
Bill
Doesn't care about tax efficient investing-
$100k salary (4% annual growth)
-
$60k expenses (4% annual growth)
-
Pays taxes on time
-
Invests everything left over
-
Generates 8% annual returns
-
Everything in taxable brokerage account
Ted
Loves tax efficient investing-
$100k salary (4% annual growth)
-
$60k expenses (4% annual growth)
-
Pays taxes on time
-
Invests everything left over
-
Generates 8% annual returns
-
Uses 401(k) + Roth IRA + taxable account
To simplify this example a bit, let’s consider only the money that Bill and Ted save during their 20s.
And let’s assume that they retire at the age of 65.
Both do pretty well for themselves, illustrating the power of compounding over the long term.
But, over time, a significant wealth gap is created between the two.
And you can probably guess who pulls ahead…
Bill
Doesn't care about tax efficient investing-
$100k salary (4% annual growth)
-
$60k expenses (4% annual growth)
-
Pays taxes on time
-
Invests everything left over
-
Generates 8% annual returns
-
Everything in taxable brokerage account
Ted
Loves tax efficient investing-
$100k salary (4% annual growth)
-
$60k expenses (4% annual growth)
-
Pays taxes on time
-
Invests everything left over
-
Generates 8% annual returns
-
Uses 401(k) + Roth IRA + taxable account
Dive into the data behind this example. Click here to open the underlying calculations in a Google Sheet. You can save as an Excel file or to your personal Google Drive.
Ted’s tax efficiency created more than $1 million in incremental, after-tax wealth.
Again, he made and spent just as much as Bill, and invested what he had left over in the exact same portfolio. Like Bill, he followed all the rules and paid his taxes on time.
But while Bill held his portfolio in a taxable account (e.g., a brokerage account with Vanguard or Fidelity or a similar provider), Ted took advantage of some tax efficient accounts:
Ted Edge #1: Employer 401(k) Match
Ted’s employer rewards employees who contribute to their 401(k) with a matching contribution, essentially giving Ted free money that Bill passed up.
Ted Edge #2: Tax Deferral + Tax Free Growth In His 401(k)
Ted contributed the maximum to his 401(k), which lowered his tax liability each year. And because this money is parked in a 401(k), he didn’t have to pay taxes on any dividends, interest, or realized gain.
Ted Edge #3: Tax Free Growth + WIthdrawal In His Roth IRA
Instead of putting his after-tax money into a taxable account, Ted maxed out his Roth IRA. This money grows tax free, and can be withdrawn without paying any taxes in retirement.
You may have heard the saying that “there ain’t no such thing as a free lunch.” In an investing context, this idea refers to the impossibility of arbitrage.
In other words, there is no such thing as riskless profit. If you want a higher expected return, you have to take on incremental risk.
But there is a free lunch in investing… taxes.
Good News, Bad News
I have two pieces of good news for you, and one piece of not-so-good news.
The first piece of good news…
You can be a tax efficient investor just like Ted.
You have the roadmap to create massive wealth without taking on any additional risk. This guide will teach you the principles of tax efficient investing, and it will provide step-by-step instructions for executing the most valuable strategies.
The second piece of good news…
The tax saving strategies in the example above are just the tip of the iceberg.
Or, if you’ll indulge the “free lunch” analogy a little longer, the extra $1 million that Ted ends up with is just the salad appetizer. Beyond that, there’s a full buffet… with an ice cream bar… with all the toppings and lots of cherries to go on top.
In this guide I will walk you through exactly what Ted did to generate that $1 million in incremental wealth. But I won’t stop there.
Because there are a lot of additional opportunities to generate even more tax free wealth.
Now here’s the not-so-good news…
I lied… just a little.
The lunch isn’t completely free.
It’s not going to fall out of the sky, or jump up and bite you in the rear.
You need to do a little bit of work to make it happen.
For starters, you need to read the rest of this guide. And you need to follow through on the strategies it suggests.
It’s going to take a little bit of work, and a little bit of time. But hopefully you see that it’s worthwhile.
That’s the One Big Myth: that there’s no free lunch. The reality is that you can generate massive alpha in your portfolio by becoming a tax efficient investor.
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Table of Contents
This page is part of our Ultimate Guide To Tax Efficient Investing. Follow the links below to read through the entire guide. Or, click here to download the full PDF version.
- Chapter 1: Why Taxes Matter (The One Big Myth) — The impact of taxes on your portfolio.
- Chapter 2: The Four (Yes, Four) Types Of Income Taxes — Understanding the “default” tax treatment your income receives.
- Chapter 3: Guiding Principles (And An “Aha Moment”) — Six rules of thumb that will make your life easier.
- Chapter 4: The 401(k) (Your Tax Free “Workhorse”) — My the 401(k) is the most powerful wealth creation account for most investors.
- Chapter 5: IRA Strategy (And the Value of Flexibility) — How to use IRAs optimally to minimize your lifetime tax liability.
- Chapter 6: Asset Location (And the Greatest Investment Ever Made) — Why it matters where you hold your bonds.