Everybody knows that taxes are a drag on performance, but I am constantly surprised at the number of investors who blithely pay taxes each year on their investment earnings without considering the impact on accumulation or the alternative strategies that they could employ.It's never a good idea to let the tail wag the dog, of course - a rational investor shouldn't seek tax avoidance, or tax minimization per se. But it makes sense to pursue the highest after-tax return.

BUILDING A TAX MODEL

Let's build a simple model to examine the impact of taxation, which varies with tax rates and the length of deferral. Our investor has a lump sum of $100,000 to invest for 30 years, after which he either liquidates the accumulation to buy a yacht, or keeps the capital intact and uses annual income or gains to finance his retirement.

Assume that his investments have a nominal (before tax) annual return of 10 percent. We will deduct federal taxes from the account as income is distributed or gains are realized. We will also assume that the investor's marginal tax rate is the account's effective rate (which would not be true for an investor who had little or no other income). Income and short-term gains will be taxed at 35 percent, and long-term capital gains at 15 percent.

CASE 1: DEFERRED LONG-TERM GAINS

In this case, our investor could buy and hold shares of stock that do not pay dividends. The effective tax rate on unrealized gains would be zero. At the end of 30 years, his investment would have grown to $1,744,940, and he will not have paid a penny of tax. If our investor dies now or anywhere along the way, income tax, though not estate tax, is forgiven, and he will never have paid any tax on the gains. A moral victory, at least.

If he sells his entire account at this point to buy a boat, his gain of $1,644,940 is taxed at 15 percent, so his net accumulation is $1,498,199. That would buy a new luxury 60-foot trawler with intercontinental range.

If, instead, our investor sells appreciated shares equal to the annual return of 10 percent, he grosses $174,494 annually. Assuming his investment was for 10,000 shares at $10 per share, each share is now worth $174.49. He must sell 1,000 shares his first year, and after adjusting for basis his profit per share is $164.49. So his net annual income (after the 15 percent long-term capital gains rate is applied) is $149,816.

CASE 2: DEFERRED ORDINARY INCOME

Here our investor finds an inspired manager who can overcome the enormous internal costs of a variable annuity, so he earns returns at the same 10 percent rate before tax as in the first case. There are no annual tax bills, so the gross accumulation is also $1,744,940. If the account is liquidated as a lump sum, all but the original $100,000 is taxed as ordinary income at 35 percent, and the remaining after-tax accumulation has shrunk to $1,069,211.

Alternatively, our investor has a gross annual income of $174,494, which is reduced by the ordinary income-tax rate of 35 percent. So, he will net $113,421. The higher tax rate on withdrawal bites into income, but there is plenty left thanks to the deferral.

CASE 3: ANNUAL REALIZED LONG-TERM GAINS

In this case, our investor purchases a mutual fund or managed account that has high annual turnover. Say the fund generates no interest, dividends or short-term gains. The effective turnover is 100 percent, and all gains are realized and taxed each year. The investment account thus compounds at just 8.5 percent per year, and the accumulation is $1,155,825.

Because he paid taxes on gains all along, the net sum after liquidation is also $1,155,825. The boat budget is about the same as for Case 2. Otherwise, our investor's annual income on his remaining $1,155,825 would be $115,582, netting $98,245 after taxes on long-term gains. The annual tax during the accumulation period reduced the pie available to convert to retirement income.

Darling, where's that bottle of wine we've been saving?

CASE 4: ANNUAL ORDINARY INCOME

Finally, the investor might opt for a fully taxable investment that generates its entire return in taxable income or short-term realized gains. (An extremely high-turnover mutual fund might produce the latter scenario.) The effective compounding rate is only 6.5 percent, because 35 percent of each year's gain is taxed away; over the years he has to cough up $280,679 for tax. Gross accumulation is $661,436.

Because he has paid taxes on all appreciation already, the net amount after liquidation is the same, $661,436. A nice used boat is still a possibility, but a galley chef is out of the question. The net annual yield from this investment will be $42,993 after income taxes are paid at the 35 percent rate. The smaller accumulation and the larger annual tax bite are devastating.

Frank Armstrong III, CFP, AIF, is the founder and principal of Investor Solutions Inc., a fee-based firm with $430 million under management, and the author of The Informed Investor.

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