Using Deferred Taxes To Increase Investment Returns

A Portfolio Management Technique That Can Help Your Long-Term Performance

Deferred Taxes and Capital Gains Taxes
Taking advantage of deferred taxes on your capital gains can be a lucrative strategy that juices returns without any of the drawbacks of traditional debt. PM Images / Photodisc / Getty Images

One approach to successful long-term investing is to hold shares for a considerable length of time (typically 10 years or more), reinvest the dividends, and periodically add to your ownership stake as money becomes available to you. A primary advantage of this philosophy arises due to the way the taxation system is setup in the United States, which creates an inherent edge that accrues to the passive strategy as the years go by and compounding works its magic.

This advantage becomes especially noticeable when you are unable to utilize tax shelters such as a Roth IRA, Traditional IRA, or 401(k) plan. By walking you through a hypothetical scenario, I hope to illustrate the numbers in stark detail so you realize that harnessing this advantage can be a very powerful way to accumulate additional wealth over your career.

Thinking of Deferred Taxes on a Low Cost Basis Investment as an Interest-Free Loan

Imagine that fifteen years ago, you bought 10,000 shares of AutoZone for $26.00 each for a total cost basis of $260,000. You stuck the stock certificates in a vault and haven't looked at them since. You check the newspaper and find that the shares closed Friday at $439.66.  Your 10,000 shares now have a market value of $4,396,600. There have been no dividends paid during the holding period.

You are now sitting on $4,396,600, of which $260,000 represents your original investment and $4,136,600 represents unrealized capital gains.

If you lived in the Kansas City are, where my companies happen to be headquartered, and were to sell your shares, you would owe a 15% tax to the Federal Government and a 6% tax to the State of Missouri, totaling 21%. Thus, of your $4,136,600 in unrealized gains, $868,686 represents taxes that you will have to pay the moment you liquidate your ownership stake in the specialty retailer.

Famed investor Warren Buffett has pointed out that the true long-term holder should think of this $868,686 as an interest-free loan from the Federal and state governments. Unlike ordinary debt, you get the benefit of more assets working for you but you have no monthly payments, you are charged no interest expense, and you get to decide when the bill comes due. As long as you continue to hold your shares, you are essentially getting $868,686 in free money working for you that will disappear if you decide to change seats and swap your stock in AutoZone for another company.

If AutoZone grows at an average of 10% per annum for the next decade, this means that in the first year alone, you would collect nearly an extra $87,000 in market wealth that you otherwise couldn't have earned simply by fact of the virtue that $868,686 is still invested for your benefit. The longer this goes on, you get this self-reinforcing cycle of wealth creation that puts the buy and hold investor at a considerable advantage to the day trader, provided the underlying securities are of blue chip quality.

Deferred Taxes Can Make It More Advantageous To Hold an Overvalued Asset Than To Swap It For An Undervalued Asset

This is one of the major reasons you don't see wealthy people or successful portfolio managers selling positions just to shift into a stock that might be a little bit of a better deal.

Say you owned $1,000,000 worth of PepsiCo built up over decades. Your cost basis is $100,000.  That means $900,000 represents an unrealized capital gain. In your case, $189,000 in deferred taxes would be carried as an offsetting liability on your balance sheet. Your PepsiCo shares are trading at 20x earnings, or a 5% earnings yield. That means your cut of Pepsi's profit each year is $50,000.

Now imagine Coca-Cola trades at only 17x earnings with the same projected growth rate and dividend payout. That is an earnings yield of 5.88%, which is 17.6% more than PepsiCo is offering in relative terms, 0.88% more in absolute terms. If your entire $1,000,000 were invested in Coke, your share of the net profits would be $58,800.  An extra $8,800 in underlying earnings is not insignificant.  

As you know by now, it's not that simple!

 Let's run the math to see what would happen if you made the switch. You sell your PepsiCo shares and see $1,000,000 in cash in your brokerage account. You immediately trigger a $189,000 Federal and state tax bill, leaving you with $811,000. You put this $811,000 to work in Coca-Cola shares at a 5.88% earnings yield, meaning your share of the earnings is $47,687 per year.  As odd as it sounds, you lost $2,313 in net earnings, or 4.6% of what you had been indirectly generating each year, despite buying an asset with a higher look-through yield.

How could such a thing happen? The loss of capital when you triggered the deferred capital gains tax meant that less money was employed for you. In this scenario, it was enough of a hit that it exceeded the benefit of the higher earnings yield on the cheaper stock. Hence the moral of the story: Once you are established and somewhat wealthy, having built your portfolio with diligence and care for awhile, flitting between company to company in a taxable account can be a costly undertaking that handicaps your after-tax results. In rare cases, it can actually make you end up poorer than you otherwise could have been despite causing your pre-tax stated returns to be higher. This is why experienced wealth managers focus on the metric that counts: The amount of risk-adjusted surplus generated each year, net of taxes and inflation, produced by your investments.

In the end, deferred taxes represent a form of leverage that has few, if any, of the drawbacks of leverage. It is a force you should at least consider harnessing if you can adapt your long-term strategy to benefit from its effects.