As part of your Continuing Financial Education (CFE), you should get in the habit of picking up 1-2 books a year on financial topics.
I know. They’re boring. It’s dull.
But you made it through 1L year and Supreme Court cases from the 1800s. You can handle some personal finance books.
If you don’t learn about money on your behalf, who will? You at least need to know the basic vocabulary even if you’re working with a financial advisor.
Today’s book is The Overtaxed Investor by Phil Demuth.
Phil Demuth is the managing director at Conservative Wealth Management (we have no financial relationship) and the author of a series of personal finance books, many of which are classics in the community.
His latest book focuses on reducing investment related taxes (yes, it’s that narrow and doesn’t cover deductions). Why would you care? Because Demuth lays out in the first chapter all the taxes you’re paying and how the tax drag is costing you major money over the course of an investing career.
Not surprisingly, he first recommends that you set up your tax-deferred accounts so that you can save money today.
The central truism of tax planning, the one we want to spotlight in CinemaScope and Technicolor by Deluxe, is that a tax deferred is a tax not paid. Once a tax is paid, your money is gone forever. Why pay a tax today when you can pay it ten or twenty years from now and earn interest on the “float” in the meantime? This is why Daddy Warbucks sings, “Tomorrow, tomorrow, I love you tomorrow, you’re always a day away.
But Roth accounts still have a place as well, despite the concern that they may be taxed in the future.
Some people fear that Congress will add Roth distributions to adjusted gross income (as they did with municipal bond income). This could trigger higher taxes on Social Security payments and raise Medicare premiums, making Roths less desirable. So would scrapping the income tax for a flat tax or a value-added tax or a national sales tax, because it means we wasted the forgone tax deductions we could have taken to fund traditional IRAs and 401(k)s.
Since theoretically a Roth account will never be taxed again, Demuth argues that you want your highest long-term expected returns in the Roth account.
The bigger this account grows, the happier you will be. Place the assets here that have the highest long-term expected return. Emerging market equities might fit this category. A small cap value stock fund would also be a good choice. More simply, stocks. I also put moonshots here. Your crazy brother-in-law works for a startup. He gets you a hundred shares. There is a 99.9% chance they are worth zero and a 0.1% chance they are worth a million dollars. Put them in a Roth if you can.
But what about your taxable account? Demuth makes a controversial (but smart) recommendation in an entire chapter dedicated to “zero-dividend investing”.
The problem with dividends showing up on your doorstep during your peak earning years is that you really don’t want them. Now don’t get me wrong, it’s great that companies are growing and producing cash, but if you’re in the 39.6% tax bracket (or, any tax bracket) with no need for the dividend income, the last thing you want is to pay tax on annual dividends distributed to your taxable account.
Warren Buffett explains this well in his 2012 Letter to Shareholders (analysis on dividends starts on page 19). Buffett says that Berkshire Hathaway doesn’t distribute annual dividends because it’s more efficient to reinvest the company’s cash in the company itself, thus increasing book value, rather than distributing that cash to investors. Buffett makes a convincing argument that you’ll be better off selling 4% of your Berkshire Hathway stock thereby creating a “synthetic dividend” than you will if Berkshire spits out the 4% to you each year.
But going Back to Demuth’s “zero-dividend investing”, he writes that ideally the overtaxed investor would prefer a broad based index fund with zero dividends. I know that I certainly would. Unfortunately, many companies in the S&P 500 distribute dividends, so the only way around them is to exclude them from your portfolio.
And no such index exists.
With computerized trading, someone might offer a portfolio of all the zero-dividend stocks in the S&P 500 (or whatever index, the bigger the better) with automated tax-loss harvesting. Unfortunately, the robo-advisors currently seem more intent on reverse-engineering Vanguard circa 1988.
Demuth also doesn’t seem to think that one will be created, in part because mutual funds themselves are on the way out.
In the future, mutual funds will be dinosaurs. Most of them already are—they just don’t know it yet. The mutual fund will be replaced by the personal fund. You will hold one fund: Fund U. It will not be exactly like anyone else’s. It will be uniquely computer-optimized to your personal ecosystem, taking into account your age, life expectancy, life-stage, employment, residence, geography, tax profile, appetite for risk, concentrated holdings, employee stock options, total indebtedness, and your personal goals. It will fit like a glove. While the mutual fund was supposed to neutralize all but market risk, the personal fund will diversify personal risk. Mutual funds are brontosauruses that have been made extinct by the giant technology meteor that just hit. It is time for them to adapt or die.
Given that there’s no practical way to implement a zero-dividend portfolio of the total market, putting one together yourself is probably not worth the headache. Not to mention that you have to weigh the uncompensated risk against the tax benefit. I don’t think it’s worth it, but I still appreciate the argument. It’s important to think about eliminating tax drag in your portfolio wherever you can.
In addition to the above, Demuth’s book contains excellent chapters on other ways investors reduce taxes (oil and gas, real estate, etc.), how to handle moving through the tax brackets at various stages in your life and what to do about estate taxes.
Overall, I think the book is well-written, even funny at times, and definitely worth your time. Pick up a copy and read it!
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Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.