Taxes: The Misunderstood Factor

Taxes: The Misunderstood Factor

By Gil Baumgarten, Segment Wealth Management, LLC

After 35 years of counseling investors, I find that certain investing factors are grossly misunderstood by many. Unfortunately, the most misunderstood is also the most important: Taxes.

As the old saying goes, knowledge comes from experience, but wisdom comes from bad experience. Even experienced investors often feel regret at tax time, not fully understanding the reasons for the extra six-figures on the check to the IRS. This regret can lead to discussion about how some strategies cause taxes that otherwise could have been avoided. 

Wall Street often pitches strategies with theoretical advantages without disclosing the tax implications, which can weigh heavily on returns. Glaring conflicts of interest arise when hiring for portfolio construction methodologies that are sometimes doomed from the start. Passive strategies have far better tax treatment, but your broker probably won’t like the low-fee approach. 

Let’s look at an example. Suzie and Simon are two investors who each invest $1 million for thirty years and achieve the same 8% annual rate of return. Suzie gets cute and sells her stocks yearly in an attempt to buy them back lower. No harm, no foul since she manages to reinstate her positions at the same price as her sells. But, this activity causes realized gains and makes them taxable. Let’s even be generous and assume Suzie only sells her stocks when she has held them for one year, entitling her to the lower long-term capital gain tax rate. On the other hand, Simon plods through the unknown for 30 years, selling everything and paying his taxes at the thirty-year mark.

Now we have two piles of cash to review with identical returns and only the effect of too-soon taxation to differentiate them. Simon’s pile is now worth $7.9 million, and Suzie’s pile is $5.9 million, both with all taxes paid. And here’s the coup de gras: If Simon’s wife dies along the way, Simon receives all of their joint property with all taxes on gains forgiven. This is true in Texas and several more states with certain community property rules. Check with your CPA for the rules that apply to you. Unfortunately, Suzie can never reap the benefit of this tax rule because she paid her taxes every year. This could boost Simon’s results by another $2.1 million, practically doubling Suzie’s results with the same rate of return. Percentages are tricky, but dollars never lie.  

Some advisors will tell you to hire them because they are smart. And they might be smart, but smart is not really good enough. To obtain a repeatable advantage, they must be more intelligent than all other market participants. It is clear that no one has successfully programmed an algorithm to play all the right cards, or the aggregate hedge fund results would be far better.

The process of attempting to outperform the market is a minefield, and the tax code is designed to make it worse. Over time, the taxes paid in the process are usually greater than the possible success of the endeavor. Choose wisely!

For more information, please contact Haley Parmer at (713) 800-7158 or Haley.Parmer@segmentwm.com.

Read more of Gil Baumgarten’s articles at Segmentwm.com/blog.