Many Wealthpreneurs are interested in building wealth through business ownership and selective investments in both public and private market assets. One such Wealthpreneuris our fictional friend Patton Thorne. He and his daughter Nicole are meeting with their CPA to discuss “tax-aware” investing. This investment perspective is important to consider whether you’re making new investments or planning to harvest gains from existing holdings.
Taxes are a drag!
The Thornes’ CPA explains taxes are the biggest drag on the investment performance of public market assets. Taxes have a greater effect than either commissions or management fees! Over a long period of time, “tax drag” could dramatically affect their wealth accumulation in both public and private asset classes.
Nicole joins Patton as he examines this table. It shows the impact of different tax rates on someone who invests $10,000 each year for 40 years at an assumed pre-tax rate of return of 8%.
Investing at a 0% tax rate is similar to investing through a tax deferred retirement account. One example is a 401(k) plan where taxation on contributions and earnings is deferred until a withdrawal by the plan participant.
The impact on final value in 40 years can be dramatic. Investing only $10,000 inside a 401(k) each year (well below the 2024 annual employee contribution limit of $23,000) would yield almost $1.2 million of additional investment assets [$2,590,565 – $1,400,380] in 40 years! Assuming an 8% annual return in subsequent years, this would result in an additional $96,000 ($1.2 million * 8%) per year in distributable earnings.
Wealthpreneur Lesson
The Rich Dad Wealth Goal
“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”
– Robert Kiyosaki
The chosen ones
The tax rate is higher on some investment assets than for others. For high-income taxpayers, interest income is currently taxable at an overall rate of 40.8 % (37% ordinary rate plus 3.8% net investment income tax [NIIT] rate). But the maximum tax rate on the sale of capital assets held for over one year is only 23.8% (20% long term capital gain rate plus 3.8% NIIT rate). Not to mention the 0% tax rate on tax-exempt bonds! The goal of tax-aware investing is to maximize after-tax returns – not simply to minimize taxes.
Not the time to let it go
In one of his annual letters to Berkshire Hathaway shareholders, Warren Buffett wrote, “Our favorite holding period is forever.” Imagine you have a portfolio of public market assets, privately owned real property assets, or privately owned businesses. All other things being equal, a lower turnover ratio within that portfolio would raise the effective after-tax growth rate, increasing the terminal wealth resulting from an investment.
If you allocate a portion of your capital to publicly traded assets, it may be wise to employ a passive buy-and-hold strategy for investments in assets with low turnover ratios. Many wealth advisors recommend implementing this approach through selected exchange traded funds (ETFs).
Some academic research indicates the returns from active management frequently do not offset the additional tax imposed on an actively managed portfolio. But this is not always the case. The after-tax returns on some short-term trading-oriented hedge funds can be outstanding!
Total turnover is not the best measure of tax efficiency. Instead, focus on net turnover (capital gains minus capital losses). A portfolio with moderate gains that aggressively harvests capital losses might produce excellent after-tax returns regardless of the tax rate.
Let’s play Rank That Asset!
Many Wealthpreneurs have a unique preference for the overall asset allocation of their public market assets. But tax-wise Wealthpreneurs also strategically spread the assets across their taxable accounts, tax-deferred accounts, and tax-exempt accounts to minimize total taxes.
To begin this asset location process, rank your investment assets by their tax efficiency from lowest to highest. Here is an example:
- Corporate bonds
- Real estate investment trusts (REITs)
- Certificates of deposit (CDs)
- Actively managed single stocks
- Actively managed stock funds
- Tax efficient funds
- Passively invested individual assets
- Tax exempt bonds
Then start at the top of the list and work your way down. This way, you fill the tax-exempt and tax-deferred accounts with the least tax efficient assets in the portfolio until you reach the accounts’ annual contribution limits.
Some wealth advisors recommend transferring the fastest-appreciating assets to the tax-exempt accounts first. These accounts are not subject to the required minimum distribution (RMD) rules on tax deferred accounts, so they can appreciate longer in a tax-favored account.
Any remaining assets can then be assigned to taxable accounts. These assets can be passively managed with infrequent gain recognition.
Don’t let the tax tail wag the investment dog
For Patton and many other Wealthpreneurs, access and control of capital is critically important, so IRAs and 401(k)s may not be a meaningful net tax benefit. Capital invested in these tax deferred vehicles is difficult to access and control due to Internal Revenue Code restrictions.
For Wealthpreneurs, savvy wealth advisors can use low-cost index solutions in taxable accounts. This allows access to solid market returns and creates the opportunity to harvest tax losses where available. Wealthpreneurs can use these losses to offset future capital gains generated through other holdings.
