Using Deferred Taxes to Increase Investment Returns

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

Deferred Taxes and Capital Gains Taxes
••• PM Images / Photodisc / Getty Images

One approach to do well with long-term investing is to hold shares for up to 10 years or more, reinvest the dividends, and add more shares to your ownership stake as you get more money. The major advantage of this doctrine is the way the tax system is set up in the U.S. It creates an innate edge to a passive plan as the years go by, and compounding works its magic.

This edge becomes more vital when you can't use other tax shelters such as an IRA or 401(k) plan. Holding shares can be a smart way to have gains over your lifetime. The following scenarios show how deferred taxes work in different situations.

A Low-Cost Basis Investment as an Interest-Free Loan

Imagine that 15 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 news 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 makes up your original investment ("basis"), and $4,136,600 is your unrealized capital gains. If you lived in the Kansas City area and were to sell your shares, you would owe a 15% tax to the U.S. government and a 6% tax to the state of Missouri. Your taxes would total 21%. Thus, out of your $4,136,600 in unrealized gains, $868,686 is the amount of taxes that you would have to pay for cashing in those stocks.

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 U.S. and the state. Unlike other debt, you put your assets to work for you, but you have no monthly payments. What's more, 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 have a lot of free money working for you. It will go to pay taxes and will no longer be yours if you decide to sell your stock in AutoZone.

If AutoZone grows at an average of 10% every year for the next decade, then in the first year alone, you would collect nearly $87,000 in market wealth that you otherwise couldn't have had. That would happen simply because your $868,686 would still be invested rather than paid to taxes.

The longer you allow this trend to go on, you gain strength in a cycle of wealth creation that puts you, the buy-and-hold investor, at a huge advantage over the day trader.

Keep an Overvalued Asset Rather Than Swap It for an Undervalued Asset

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

Suppose you owned $1,000,000 worth of PepsiCo built up over decades an that 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 that 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 paying 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. Anadditional $8,800 in earnings is not a minor amount. 

As you know by now, it's not that simple. Let's run the math to see what would happen if you were to make the switch.

Suppose you sell your PepsiCo shares and see $1,000,000 in cash in your brokerage account. Right away, you trigger a $189,000 U.S. and state tax bill, leaving you with $811,000. You put that $811,000 to work in Coca-Cola shares at a 5.88% earnings yield, meaning that 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 you put less of your money to work for you. In this scenario, it was enough of a hit that it beat the benefit of the higher earnings yield on the cheaper stock. Hence, the moral of the story: Once you have earned some wealth through building your portfolio with clear intent and care, flitting between stocks in a taxable account can be a costly move that hurts your after-tax results. 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. This thinking is how people get rich from their investments.

In the end, deferred taxes are a form of leverage that has few, if any, of the drawbacks of leverage. It is a force you should try to harness to adapt your long-term strategy to benefit from its effects.