As investors build up their wealth, they can accelerate their progress by capitalizing on tax planning opportunities. The tax code contains numerous vehicles that can facilitate the accumulation of wealth. Investors who utilize qualified retirement accounts enjoy advantages that can mean the difference between a comfortable, early retirement and a poverty-stricken, late retirement. The purpose of this article is to demonstrate, in some selected examples, how effective tax planning can accelerate the building of wealth for retirement and how ineffective tax planning can hold back even an astute investor.
Sam: The Investor Who Fails to Consider Taxes
To begin with, assume Sam receives a $5,000 bonus each year. The bonus is declared in December and paid in January. His marginal tax rate is 40%, which measures the incremental portion of ordinary income that is lost to Federal and state income taxes. In other words, Sam incrementally pays $40 of tax on his top $100 of ordinary income. When Sam receives the $5,000 of income, he is subject to additional tax of $2,000, or 40% times the $5,000 of income. He therefore has $3,000 remaining, invests the cash in stocks, and is an active trader with no single investment held long enough to qualify for a favorable long-term capital gains tax rate. For simplicity, assume the transaction costs from his trades are insignificant, his investments earn an average return of 10% before tax per year, and the bonus triggers no other incremental taxation. His after tax rate of return is 6%. (Note: 6% = 10% less 40% of the 10% for taxation.) If Sam makes investments of $3,000 at the start of each year for 30 years, Sam can accumulate $251,405.03 at the end of 30 years.[1]
Samantha: The Investor Who Utilizes Tax Planning
For comparison, assume Samantha’s position is similar to Sam’s and she too receives a $5,000 bonus at the beginning of each year. Sam and Samantha plan to retire in 30 years. But she has learned a few things about taxation. She is aware that her employer offers her a qualified retirement account, such as a 401-k account. When she elects to use the 401-k option on her bonus, she can request that her employer reduce her salary by the $5,000 in exchange for the employer’s agreement to fund the 401-k with the $5,000. She avoids any current income tax on the $5,000 and the fund grows tax-free during her working years. Assuming she directs investments of $5,000 at the start of each year for 30 years, she can accumulate $904,717.12 at the end of 30 years.[2]
Comparing Sam and Samantha
Samantha’s account far exceeds Sam’s but the two accounts differ in their future taxation. At the end of 30 years, Sam’s account is subject to little or no additional taxation because he has been repeatedly paying tax on each transaction. In other words, Sam holds a portfolio of stock whose tax basis approximately matches its fair market value. But he will owe tax on any future gains. On the other hand, Samantha’s account, at retirement, will be subject to taxation at ordinary income tax rates. She visualizes setting aside 40% of her account and its growth to cover income taxes and holding the remaining 60% and its growth as available to her. Then the after tax value of her account at the end of 30 years is $542,830.27, or 60% times $904,717.12, which is the figure computed above. Her account, even on an after tax basis, far exceeds Sam’s.
The exact computation of her taxes during her retirement years will depend on how she withdraws funds, but for our purposes this estimate captures the essence of her tax burden measured as of the date of her retirement.
Sam Adjusts His Strategy: Long-Term Capital Gains
Now suppose Sam learns a few things about taxation and adjusts his strategy by holding each investment long enough to qualify for a long-term capital gain tax rate. He purchases stocks that pay no or insignificant dividends. Nevertheless, he still trades fairly frequently by selling each stock at the end of a one-year holding period. Although the rules on capital gains vary over time, this paper assumes a long-term capital gain tax rate of 20% when an investor holds an investment in stock for longer than one year (e.g. one year plus one day). Assume his marginal tax rate on his investments falls to 30%, which is the sum of 20% for federal income tax based on long term capital gains and 10% for state income tax. Otherwise, his story remains the same. He deposits $3,000 at the start of each year, earns a 10% return before tax, and earns a 7% return after tax. (Note: 7% = 10% less 30% for taxation.) Sam can accumulate $303,219.12 at the end of 30 years.[3] Samantha’s account is still larger, but Sam’s tax planning has narrowed the gap.
Sam Adjusts His Strategy: Long-Term Capital Gains and a Better Selection of Stocks
Now suppose Sam, as described above, holds his investments long enough to qualify for long-term capital gain tax rates. In addition, by studying investment newsletters and web sites, he believes he can select winning stocks and earn a 12% return before tax and an 8.4% return after tax. (Note: 8.4% = 12% less 30% for taxation.) Otherwise, his story remains the same. If Sam is correct in his assumptions, he can accumulate $396,546.68 at the end of 30 years.[4] Samantha’s account is still larger. Even with the strong assumption that Sam can beat an average market return, Samantha’s tax planning is still more effective.
Discussion
Why is Samantha successful? Her qualified retirement account allows her to deposit $5,000 per year rather than $3,000 per year. $2,000 of each $5,000 represents a tax component that can grow and cover her future taxation. The remaining $3,000, in essence, is growing tax free at a market rate of 10%, not at a much reduced tax-free rate that might be available on municipal bonds. Proof of this principle can be seen in the following example. Let Samantha split her account into two parts: one for taxation and one for herself. She puts $2,000 of each $5,000 bonus into the tax account and $3,000 of each $5,000 bonus into her own account. Let the two accounts grow at 10% per year. At the end of 30 years the tax account exactly covers her tax burden of $361,886.85 and her own account has grown to $542,830.27, which matches the after tax valuation that was computed above.[5] Even Sam’s superior stock selection cannot produce an after tax return of 10% on his deposits of $3,000. Tax planning has provided Samantha, an average investor, with greater wealth than Sam, who is assumed to be superior at stock selection. In reality, if investors such as Sam assume they can beat the market, many of them will be sadly mistaken and may end up underperforming the market. This risk of underperformance magnifies Samantha’s advantage.
Other Issues That Favor Samantha
There are numerous other issues that bear on the comparison of Sam and Samantha. Many of the issues only strengthen Samantha’s position. First, savers like Samantha might receive matching contributions from their employers if they make deposits into qualified retirement accounts. If matching is available, Samantha’s advantage grows substantially.
Next, Samantha’s approach can help her develop a habit of saving. Many individuals have found it difficult to save. The United States has a saving rate that is low relative to rates found elsewhere in the world. Some studies even find the U.S. savings rate to be negative at times. Samantha’s retirement plan can help her save by discouraging her from carelessly invading her savings for short-term gratification. Generally, if Samantha considers taking early distributions from her qualified plan, she will see a warning that such a distribution is normally subject to ordinary taxation plus a penalty. The warning may deter her from taking the early distribution. On the other hand, with no warning, Sam is free to invade and waste his savings.
Another advantage for Samantha is based on marginal tax rates. Many individuals estimate that their marginal tax rates will be lower in retirement than during their working years. This factor can make Samantha’s advantage even greater. In general, a lower marginal rate during retirement favors investments in qualified retirement accounts. Of course, if an individual estimates a higher marginal rate during retirement, this factor incrementally reduces Samantha’s advantage.
Another issue concerns the selection of stocks. Samantha’s type of qualified plan typically restricts her to a limited number of investment choices. But hopefully the choices are among professionally managed funds that can, on average, earn the market return. Sam’s approach exposes him to his own hubris: the possibility of thinking that his own, frequent trades will outperform the market. Research in finance suggests that people like Sam will frequently be sadly mistaken and Sam may even end up underperforming the market. In other words, assuming she has reasonable investment options in her retirement plan, Samantha’s strategy may protect her from her own hubris.
Transaction costs also favor Samantha’s position. In a typical Vanguard index fund, Samantha may only incur costs of approximately .18% or less of the account per year. Sam’s transactions costs are likely to be higher.
New Assumption on Average Market Return
Some might view the assumed market return of 10% as conservative. Although average returns vary with time periods and the types of firms in a sample, there are some widely discussed averages. For example, Ibbotson (Ibbotson Associates Inc., Stocks, Bonds, Bills, and Inflation, 1998 Yearbook, Ibbotson Associates, Chicago, 1998.) reports an average return of 13.2% on large-company stocks from 1926-1998.
Assume Sam, the frequent trader, earns this average return of 13.2% on deposits of $3,000 per year at the start of each year for 30 years. His marginal tax rate on his investments is 30%. His after tax rate of return is 9.24%. (Note: 9.24% = 13.2% less 30% for taxation). His accumulation value at the end of 30 years is $467,201.02.[6]
For comparison, if Samantha utilizes her qualified retirement account, deposits $5,000 per year at the start of each year, earns an average return of 13.2%, and has a 40% tax burden at retirement, then her accumulation value at retirement after tax is $1,035,446.62.[7] The basic principle remains: Samantha’s effective tax planning leads to a larger retirement account.
Large-Company Stocks and Small-Company Stocks
Investment returns, as mentioned above, can vary based on the types of stocks in an investor’s portfolio. Ibbotson reports that large-company stocks have earned an average return of 13.2% from 1926-1998 while small-company stocks have returned 17.4% over the same time period. The small-company stocks have higher returns due to higher risk.
Assume Sam, the frequent trader, tries to enhance his savings by turning to small-company stocks and earns an average return of 17.4% on deposits of $3,000 per year at the start of each year for 30 years. His marginal tax rate on his investments is 30%. His after tax rate of return is 12.18%. (Note: 12.18% = 17.4% less 30% for taxation). His accumulation value at the end of 30 years is $969,875.68.[8]
For comparison, assume Samantha utilizes her qualified retirement account and invests in large-company stocks to reduce risk. She deposits $5,000 per year at the start of each year, earns the average large-company return of 13.2%, and has a 40% tax burden at retirement. Her accumulation value at retirement after tax is $1,035,446.62.[9] The basic principle remains: Samantha’s effective tax planning leads to a larger retirement account.
Conclusion
Effective tax planning can help individuals achieve their financial goals. This paper demonstrates how the utilization of a qualified retirement account can produce greater wealth than various, popular alternatives. In the examples in this paper, effective tax planning that combines a qualified retirement account with average stock selection can defeat a strategy that assumes superior stock selection but ineffective tax planning.
Notes
[1] Sam’s accumulation value is based on the future value of an annuity. The standard formula for valuing an annuity must be adjusted because the annuity payments in this paper occur at the beginning of each period rather than the end of each period. Each deposit represents an annuity payment. Returns are compounded annually. The future value F of a standard annuity with payments at the end of each period is given by the formula:
F = A x [(1 + i )n – 1] / i where:
F = the future value of the annuity
A = the amount of the annuity payments
i = rate of return
n = number of periods
In the first example for Sam, the formula gives:
F = 3,000 x [(1 + .06)30 – 1] / .06 = 237,174.56 = the value at the beginning of the last year.
Adjusting this result for gains over the last year gives:
237,174.56 x (1 + .06) = 251,405.03
Equivalently, combining all computations into one formula gives:
F = {3,000 x [(1 + .06)30 – 1] / .06} x (1 + .06) = 251,405.03
[2] F = {5,000 x [(1 + .10)30 – 1] / .10} x (1 + .10) = 904,717.12
[3] F = {3,000 x [(1 + .07)30 – 1] / .07} x (1 + .07) = 303,219.12
[4] F = {3,000 x [(1 + .084)30 – 1] / .084} x (1 + .084) = 396,546.68
[5] F = {2,000 x [(1 + .10)30 – 1] / .10} x (1 + .10) = 361,886.85 F = {3,000 x [(1 + .10)30 – 1] / .10} x (1 + .10) = 542,830.27
[6] F = {3,000 x [(1 + .0924)30 – 1] / .0924} x (1 + .0924) = 467,201.02
[7] F = {5,000 x [(1 + .132)30 – 1] / .132} x (1 + .132) = 1,725,744.36. Then adjusting for the tax burden of 40% gives: 1,725,744.36 x .6 = 1,035,446.62
[8] F = {3,000 x [(1 + .1218)30 – 1] / .1218} x (1 + .1218) = 969,875.68
[9] F = {5,000 x [(1 + .132)30 – 1] / .132} x (1 + .132) = 1,725,744.36. Then adjusting for the tax burden of 40% gives: 1,725,744.36 x .6 = 1,035,446.62
