You ever have one of those moments where you are trying to recall the name of a movie, or an actor’s name, or the name of your first grade teacher, etc? You know the feeling….the “this is going to drive me nuts until I think of it” feeling.
Just as I tried to go to sleep the other night, I had that feeling about something. After battling this feeling for an hour, I eventually gave in, crawled out of bed, and decided to blog about it.
My thought was no movie title or former teacher, but something much more boring….
DO people really understand the effect that taxation can have on their investment portfolios?
I know. I am a weirdo. Yes, I was thinking about taxation when I should have been dreaming. However, my thoughts about taxes are not some vanilla opinion like “the more you pay in taxes, the less money you will end up with.” Thank you Captain Obvious. You folks know my style – save the weak comments…either come strong or don’t come at all!
HYPOTHETICAL TAX FREE WORLD
People have differing opinions on what their utopia would include, but in mine taxation would be buried 6 feet deep and have a headstone that read “R.I.P.” Hey, I said it was utopia, right?
What if a resourceful person could take $1 and double it 20 times without taxation? What would their total portfolio grow to? Start with $1, then double it to $2, then to $4, $8, etc. After 20 doubles, they would have over $1 million ($1,048,576 for my engineers, actuaries, and OCD people that demand the details). Don’t take my word for it….I did not believe it myself until I calculated it. With that in mind, it looks like this:
$1 $2 $4 $8 $16 $32 $64 $128 $256 $512 $1,024 $2,048 $4,096 $8,192
$16,384 $32,768 $65,536 $131,072 $262,144 $524,288 and then $1,048,576
Game over. Retired! At the beach. Umbrella drink. Supermodel. What about your wife? She has one too! Nobody cares anymore!
Now, please try not to panic when you read this heresy next sentence. This world will never happen because taxation will never disappear. If someone out there finds a way to make it disappear, I know a guy that will meet you in the middle of the night and drive the getaway car.
BACK TO REALITY
Here on planet Earth, the IRS taxes a short term capital gain (one where the investment is held less than 1 year) the same way as they tax ordinary income. If your highest marginal bracket is 28%, then you will pay 28% on your short term gains as well.
So, let us run the same scenario, except this time lets withhold 28% of the gains each year. In year one, the buck turns into two bucks, but then the IRS steals takes $.28 of that $1 gain so we net only $1.72. With me so far?
Now, before I give you the answer…what is your guess at the final number after 20 doubles and a 28% tax on the annual gains? Be honest. Considering that the tax-free answer was $1 million, my guess was around $400,000. I figured that if you take 28% each year, by the time you account for the compounding, you would end up with about half as much money. Then, logic spoke up and said “nah, it would be slightly less than half.”
I guessed $400,000.
What is your guess? Think about that number and write it down on a post-it note. If there is a sharp object resting anywhere near you, you might want to put it away before you read this next part.
If you double the dollar twenty times and take out 28% of the gains each year for Uncle Sam, you end up with…..wait for it……
No longer retired. Supermodel gone. Mai Tai is watered down. Back to work!
asking yourself* That can’t be right. What if it is? Would this weirdo actually write about it without checking his facts? He might. He is a weirdo. Nah, it is only 28% so instead of a million, I should have 700 thousand or something right? am I close?**
In case YOU, sir, are a “doubting Thomas,” I shall provide the figures for you.
$1 $1.72 $2.96 $5.09 $8.75 $15.05 $25.89 $44.53 $76.60 $131.75 $226.61 $389.77
$670.41 $1,153.11 $1,983.34 $3,411.35 $5,867.53 $10,092.15 $17,358.49 $29,856.61 and then….$51,353.37
If anyone would like to see the spreadsheet, send me an e-mail.
So, the next time you see on Fox News that the Democrats and Republicans are arguing again over future tax brackets, think back to this blog entry. They are negotiating for a LOT of money. It makes a H U G E difference!
Of course, a savvy advisor can work with you to attempt to minimize the taxation on your investment portfolio. This experience may result in the investor keeping more of their money. Of course, we do not give tax advice, but if your advisor does not consider taxes at all when handling your money, perhaps it is time for a change.