Avoiding Taxing Activity

ou can't evade taxes without going to jail, and you can't avoid taxes without a clever sheltering strategy, but you can help to delay taxes with index funds. Tax-sheltered accounts, from IRAs to 401-k to pension plans, all make the issue irrelevant for many assets. But for those assets that are not covered by such plans, and inevitably every investor has a substantial amount of such vulnerable assets, careful attention should be paid.

After a series of tax reforms in the last two decades, capital gains in the United States have become taxed at a much lower rate than ordinary income for most people. Price appreciation of a stock is a capital gain, while dividends or bond interest is classed as ordinary income. So all else being equal, you want to own stocks that pay few dividends and plow their earnings back into the company to grow the stock price. Bonds are to be avoided. Of course, all else is not equal because bonds offer security that stocks never can. The important fact remains that capital gains are more desirable. They are so desirable that a plausible argument can be made that the run-up in stock valuations (such as high P/E or price/book value ratios) is entirely reasonable given the after-tax superiority of stocks.

Delaying capital gains is the next great precept of tax minimization, and here is where indexing comes in. Equity index funds are extremely tax-efficient because they allow the taxpayer to delay realization of the vast majority of capital gains until it is time to leave the fund. The opposite is true for active funds with a tendency for high turnover (heavy trading), which forces regular payments to Uncle Sam for realization of capital gains.

Tax Rule: Capital gains are "realized" and taxes on them due when an asset is sold.

The mutual fund is a pooled investment entity in which each investor owns a set portion of the pool of assets, so when taxable gains occur, investors are notified along with the IRS of their portion. Realized gains are declared periodically by funds in what is known as capital gains distributions.

The effect of paying taxes early is not nearly as disastrous as the effect of paying unnecessary fees. At least with taxes, everybody must pay—it's just a matter of when. The difference is in the opportunity cost of not being able to earn gains on the tax money paid early on. In Figure 13.1, we compare $10,000 funds with low and high turnover. Given the assumptions in Figure 13.1, including equal returns and fees, we can calculate what will happen purely as an effect of taxation.

As with any asset that compounds with time, the length of the investment period in question is the biggest factor in determining the damage, on both a percentage and absolute basis. Thus, if your time horizon is quite short, then maybe it's not a concern. But most retirement funds are by definition quite long in their time horizon. If you are saving for your children and perhaps for their children, it's hard to say just how long the time horizon is, but it's certainly measured in many decades.

Now for the really cruel trick occasionally played on the earnest active fund investor. In times of market decline, they sometimes pay far more

After Tax Effects of High Turnover

After Tax Effects of High Turnover

Years

Assuming identical 10% fund performance for both funds, common 25% capital gains rate, high turnover fund realizing 50% of its gains per year.

Low turnover fund has no realized gains until Year 20, when fund is sold and all assets taxes paid.

Years

Assuming identical 10% fund performance for both funds, common 25% capital gains rate, high turnover fund realizing 50% of its gains per year.

Low turnover fund has no realized gains until Year 20, when fund is sold and all assets taxes paid.

than their fair share of taxes! This happens because, as described above, all taxable gains are pooled during the year and then officially distributed at various points during the year, typically quarterly and at least once near the end of the year. The key to remember is that there is a day of record when the investor is officially liable for the latest period of distributions. Investors who decide to redeem their shares and flee a fund before that date get the full proportional value of capital gains and income but do not get stuck with the tax bill for that quarter. It's the remaining loyal supporters who pay their share!

This is not such a problem when investors come and go in a smooth flow at regular intervals. Of course, that is not what happens in real markets. Money floods into the market in good times, while eager investors chase high historical returns and play the momentum game. When the business cycle turns down, and inevitably it does, investors pull some of their money out of equity funds and seek the shelter of bonds. In true bear markets this happens with a vengeance. (Even though a given year saw a dip in the portfolio's net asset value, inevitably it will hold some items that have unrealized capital gains from previous years' activity.) So the loyal active investor is hit with a double whammy: a terrible year for returns, and unusually high capital gains distributions!

Well, that should be enough for someone new to indexing to consider at the moment. In the next part of this book, we turn to concrete plans of action.

PART II

Taking Action

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Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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