The Taxable Investor's Manifesto

Wealth Management Strategies to Last a Lifetime

Stuart E. Lucas

• Publisher: Wiley
• Year: 2020
• Print ISBN: 9781119692034
• eBook ISBN: 9781119692027
• Edition: 1
• Topic: Développement personnel
• Subtopic: Finances personnelles

The Taxable Investor's Manifesto: Wealth Management Strategies to Last a Lifetime is written for every investor with taxable wealth and every advisor who serves them. The Taxable Investor's Manifesto guides readers through a series of related topics, bringing clarity to complexity with an economy of words, while providing valuable and actionable advice at every turn.

This remarkable book combines the deep industry knowledge of a seasoned practitioner with the communication skills of a leading educator. Author Stuart E. Lucas is the founder and Chief Investment Officer of Wealth Strategist Partners, a firm that advises complex family enterprises, including his own. He also co-founded the University of Chicago's Private Wealth Management program, now in its fourteenth year.

Most investment books only address pre-tax headline returns, but individuals pay taxes. The incentives and disincentives of our tax system can have a dramatic impact on actual investment time horizons and returns. The Manifesto sensibly folds tax incentives into investment strategy in ways that can add profound value over a lifetime to actual results. It includes guidance on:

• How to keep a greater percentage of your profits with a higher probability of success and less effort
• Why it's important to manage the intersection of investment, tax and estate planning
• How to compete for better long-term investment returns against tax-exempt investors.

Whether you're a young professional or entrepreneur, a mid-career manager, a senior business executive, or a retiree this book will give you tools to enhance your net worth considerably. If you are an advisor, studying and implementing Lucas's advice will strengthen your business and make your clients happier.

CHAPTER ONE
Taxable Investors Need to Think Differently

What makes a good investment? It's such a simple question, but not an easy one to answer. We never know in advance whether an investment will succeed. By their very nature, investments involve uncertainty. Nevertheless, one can evaluate proactively whether something is a good investment. To me, a good investment has more upside potential than downside risk; it's asymmetric. The investment becomes even more attractive when its upside can compound for a long time; it has high potential magnitude. A third valuable attribute is a favorable probability of success; 30% odds of doubling one's money is a lot better than 10% odds of doing so.

Another important characteristic that drives investment attractiveness is the percentage of the profit from a successful investment that the investor actually keeps, profit retention. Profit retention is different than asymmetry, magnitude, and probabilities because taxable and tax-exempt investors operate with different rules. A tax-exempt investor – like an endowment, foundation, or retirement plan – may keep 90% or more of the profits from a high-yield bond fund each year, and it can reinvest the entire 90%. The other 10% or so goes to the fund manager in the form of fees. On the other hand, a taxable investor based in California or New York earns and can reinvest maybe 50% of the profits because, in addition to paying the investment manager, the taxable investor must also pay taxes on income and capital gains. Through the lens of that taxable investor, the management fees aren't 10% of retained profits; they are more like 20% of the after-tax return. It's the same investment but with very different results. For hedge funds the tax-exempt investor keeps maybe 75% because of the higher fee structure. On the same investment, the taxable investor nets 45% or less.¹

Retaining 75% to 90% of the same gross profits versus 45% to 50% can have profound effects on symmetry, magnitude, and probability assessments, especially when asset growth compounds over years and decades. But almost no one – academics, advisors, clients – has done the math, measured the differences, and adapted investment strategy or tactics to take these differences into account.

When we pay tax, that portion of profit goes to the government and is no longer in our portfolio. It can't grow for us, it can't pay dividends, it's removed from an advisor's assets under management. On the other hand, if tax payments on an investment can be deferred, the amount that otherwise would be used to pay tax in a given year has the potential to keep compounding, indefinitely.

Success as taxable investors comes with additional challenges. The more we defer tax payments and the higher the magnitude of the gain, the bigger the tax bill at the eventual sale. A highly appreciated asset worth $1 million and paying a 2% dividend before tax could, after it is sold, end up being worth only $750,000 after capital gains taxes are paid. Over time, any replacement investment needs to appreciate at a faster rate than the old one just to break even in dollar terms, and it needs to generate a 33% dividend boost to maintain cash flow. This isn't an issue for tax-exempt investors, and their investment managers have no need to think through the problem.

Being seen as a successful money manager is good business. Skillfully crafted brochures and sales pitches describe investment processes that involve careful analysis of investment options, how decisions are made to buy the best ones, regular reevaluation of those decisions as relative values change, and how to upgrade the portfolio to achieve the best possible results. Tax-exempt investors are indifferent about whether a manager makes a thousand decisions a minute, ten a week, five a month, two a year, or none at all, as long as the results are there.

That's not the case for taxable investors. Through our lens there is a fundamental tension between manager activity and our net results. The combination of rising stock prices and manager activity can be very expensive for us, even when it benefits tax-exempt investors. Selling a financial asset triggers tax on profits; that tax reduces return, undermining profit retention and magnitude. None of it is reflected in the way investment performance is typically presented.²

Given all these differences, it's not acceptable to manage taxable and tax-exempt portfolios using the same investment theories, the same analysis, the same structures, and the same metrics of performance. We taxable investors need to think and act differently, and our advisors should too. This manifesto will tell you how.

We need to think differently because taxes claim between roughly a quarter to a half of potential profits, and taxes skew relative risk symmetry, profit magnitude, retention rate, and probabilities of winning. Plus, we aren't talking about just one investment. Most of us will make many investment decisions over decades and decades. We need to factor in the relationship of each investment to our entire investment program. Each time we receive interest income or dividends, we have to pay tax. Selling any investment also has tax consequences.

Importantly, the tax code tells us to sum all our investment gains and losses for a given year and pay tax only on the net realized gains over the course of that calendar year. If we have net realized investment losses in a year, they are “carried forward” to be offset against net realized gains in future years. Investment losses cannot be used in any material way to offset earned income for tax purposes³ or to “claw back” previous taxes paid. It's an oversimplification, but think of tax on investments and on earned income as two separate, independent calculations.

Tax rates are not uniformly applied either: we pay a tax rate on investment income, on short-term capital gains, and on earned income that is about 50% higher than the rate payable on long-term capital gains. Unrealized capital gains can grow tax deferred until the security is sold, sometimes years or decades after purchase. But taxes on earnings, investment income, and realized gains must be paid currently. The character, scale, and timing of profits all impact what ends up in our pockets. When tax is paid, the opportunity to compound those lost dollars in our portfolio evaporates – forever.

In the world of taxable investors, the interplay of fees and taxes also affects profits. Depending on an investment's structure, sometimes fees reduce taxable and actual profits equally. For example, management fees and expenses in mutual funds and ETFs are deductible from profits before calculating taxes. However, under the Tax Cut and Jobs Act of 2017, for hedge funds, private equity funds, other limited partnership funds, and separate accounts, investment management fees do not reduce your taxable profits, even though they reduce your actual profits. You read this correctly, the investment structure causes taxable profits to be higher than actual profit. The tax character of these fees makes them particularly costly.

When these costs cannot be deducted from taxable profits, effective tax rates can soar, especially when pre-fee profits are modest. Let's take a simplified, but directionally correct, example. A taxpayer invests $100 with a hedge fund that earns a modest 4% return in a given year before management fees of 1.5% on invested capital, for a net return of 2.5%. The combination of factors – including characterization of income and the investor's state tax rate – result in a 35% tax rate applied to the investor's $4 gross, pre-fee profit. The resulting tax is $1.40. As a result, the investor pays an effective tax rate of 56% on $2.50 of after-fee, pretax profit, and is left with a measly $1.10 net, or 27.5% of the gross profit. As taxable investors, we need to evaluate the interplay among investments, taxes, and structures because it matters – a lot.

Figure 1.1 shows a straightforward framework for taxable investing.

Just because tax efficiency is valuable, it does not stand to reason that all tax-efficient investments are good. Life insurance is widely sold as a way to eliminate taxes on profits and to avoid estate taxes, but it will only be a good investment if the underlying structure, terms, and assets are sound. Similarly, Qualified Opportunity Zone funds, approved in the 2017 Tax Act, are tax efficient. But they will only serve taxable investors well if the underlying investments generate decent profits. One of the potential issues with vehicles that shield you from taxes is that if the investment turns out to be a loser, you will suffer 100% of the loss. Ironically, not all losses are bad if they are structured properly and the government is your partner in the loss. Later in the book, we will explore an investment technique called tax-loss harvesting, where one explicit purpose of the strategy is to realize losses in part of your investment portfolio to offset the tax otherwise payable on other realized investment profits.

FIGURE 1.1 A FRAMEWORK FOR TAXABLE INVESTING.

Parenthetically, as we've already explored, some investments may appear to generate decent returns, but after being subjected to inefficient structures, high fees, and tax rates of 50% or more, in fact they aren't so great. As a general rule, the shorter the hold period of an investment and the more of its total return that comes in the form of taxable income, the higher the risk-adjusted, pretax returns need to be in order to justify their inclusion in taxable portfolios. In the chapters ahead, we will explore further how to invest in that upper-right-hand quadrant with consistency and success.

Most predictably, the best investments for taxable investors are ones that generate decent to strong capital gains for long periods of time. Nevertheless, even with success there are consequences. As unrealized gains grow, a rigidity creeps into taxable portfolios: the more successful an investment becomes, the more expensive it is to sell and the harder it is to replace. With greater rigidity, each decision about whether or not to sell becomes more important and more deserving of studied, professional analysis.

Estate planning can also have a big influence on where an investment falls in the two-by-two matrix shown in Figure 1.1. Anyone can establish tax-deferred or tax-exempt retirement plans. Assets that would otherwise be in the bottom half of the matrix move to the top half if they are in one of these vehicles. Tax-inefficient assets within retirement plans add diversification in the traditional sense. They also give you the means to manage future changes in tax rates. As wealth grows there is also the opportunity to share it with others: children, grandchildren, philanthropies. Good estate planning can be incredibly valuable, both for tax planning and for perpetuating family business.

In some ways, all these moving parts add complexity to taxable investing. But an investment strategy, designed and executed with forethought and care, will minimize the adverse impact, and maximize the upside ...

Table of contents

• Cover
• Table of Contents
• About the Author
• Acknowledgments
• Introduction
• CHAPTER ONE: Taxable Investors Need to Think Differently
• CHAPTER TWO: Diversify at the Right Time and in the Right Way
• CHAPTER THREE: Generate Value from That Magical Liability: Deferred Tax
• CHAPTER FOUR: If You Want Wealth to Grow, Own Stocks
• CHAPTER FIVE: Lengthen Time Horizon to Lower Risk and Enhance Returns
• CHAPTER SIX: Control Cash Flow to Perpetuate Purchasing Power
• CHAPTER SEVEN: Don't Be Misled by Performance
• CHAPTER EIGHT: Get Value from Active Management
• CHAPTER NINE: Approach Alternative Investments with Skill and Skepticism, or Not at All
• CHAPTER TEN: Plan Your Estate: It Adds More Value Than Investing
• CHAPTER ELEVEN: Shift from Success to Significance
• CHAPTER TWELVE: Reinforce Positive Family Culture through Financial Design
• CHAPTER THIRTEEN: Evaluate the Risks to This Approach
• CHAPTER FOURTEEN: Select an Advisor with Strong Investment Skills, an Interdisciplinary Approach, and a Fiduciary Mindset
• APPENDIX Additional Books about Taxable Investing
• Index
• End User License Agreement