Who wants to pay more taxes? Nobody that I work with. But what if I asked if you would you be willing to pay more taxes to be even wealthier? Why do we seem to be obsessively fixated on the taxes, rather than the net result?
I believe it is because we taxpayers are conditioned to take all necessary, legal measures to lower what we owe the IRS. While, as a CPA, part of my job is to help clients pay less taxes, the analysis must be comprehensive. Would you ask for a pay cut in order to reduce your tax bill?
So why are investors willing to accept less growth and income from an investment portfolio purely to save taxes? As history shows us, the best way to grow wealth in the stock market over the long term is to invest in an appropriately-allocated equity (stock) portfolio and then leave it alone except to rebalance. The historical return for stocks (equities) since 1926 is 10% – 12% with dividends reinvested. Yet, I continue to find investment portfolios filled with low-rate municipal (“muni”) bonds put there to save taxes. Why give up superior long-term growth in favor of a loan that will return only face value along with 2% – 4% interest? Let’s compare the results for an investment of $100,000 over 30 years:
- 30-year AAA muni bonds paying 3% as of 8/4/15 (source: FMS Bonds, Inc.)
- Equity mutual fund portfolio returning only 8% with dividends reinvested over the same time period
- Top long-term capital gains tax rate of 20% (2015 rates, assuming 100% of portfolio sold in one year
But what about the “risk” of investing in the stock market? In the “short term” (less than five years), people don’t invest, they speculate. Speculation is risky and gives real investing a bad name. Done properly, though, the risk of losing money in the stock market in the long term (a minimum of five years) is far lower than letting inflation steal your nest egg. The key, of course, is to invest your hard-earned money properly, which means:
- Within the context of a financial plan, as a way to reach your goals,
- For the long term only (again, a minimum of five years), and
- In a well-allocated equity mutual fund portfolio, rebalanced annually and otherwise left to grow.
Tax savings, while important, is secondary to growth and income. The goal is to pay as little taxes as possible on the maximum growth and income possible. And, seriously, are you really ok with $190k instead of $825k? And we’re not even getting into the effect of inflation over the next 30 years – or what you would have if the stock market returns its average of 10% – 12%!
I’ve really beaten up on bonds in this post. Do they ever have a home in our portfolios? Yes, but only in proper context. Find out what I mean in Bonds: when and why to buy.