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How Deferred Tax Makes You Rich

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Deferred Tax Explained - MakeLivingGoodWarren Buffett is THE most successful value investor this world has ever known. But do you know what is the secret of his success? It’s Deferred Tax.

Deferred tax means that an investor has held onto his profits in the investment and hasn’t booked the profit. How will this help you become rich? Well, when you do not book profit on your investment, meaning you didn’t sell and settle the account, you haven’t earned any real profit. Unless profits are transferred to your account, there’s no tax that you need to pay on it. That’s what makes deferred tax interesting.

This is a legitimate way to become rich too which many great investors of our century have exploited. As a common man, we get too excited to see few extra percentage of profits on our stock investments and eventually sell it.

A common investor’s mindset is fixated on the short term profits. He is constantly thinking what if his portfolio goes down tomorrow, he will loose all the profits he has earned so far. This leads him to sell the stocks too soon. What he doesn’t realize is that after selling the stocks, an investor needs to pay tax on any profit earned in addition to transaction fees that his brokerage firm will charge him as well.

I personally use Robinhood for buying and selling stocks in my portfolio. The reason I like this app is because it offers $0 brokerage fee for any number of transactions I do which means I save a good amount money spent in brokerage fees otherwise. I highly recommend you to check it out. When you register with my link, you  will also be awarded with a free stock of any US company by Robinhood. It’s a great way to start stock market investment.

 

Warren Buffett Company

When Warren started his company – Berkshire Hathaway, the price of one stock was just $19 and today its whopping $329,500 a piece. You can probably buy a house by selling just one stock of Berkshire Hathaway if you were lucky to have one.

Berkshire Hathway Share Price Today - MakeLivingGood

This massive rise in price of his company’s stock isn’t due to reverse splitting of the stocks but plain growth.

Reverse splitting

a common practice by companies having stock prices in pennies to combine multiple shares and sell them as bundle; is called reverse split.

 

Rather Berkshire’s stock price rise was due to enormous profits accumulated over the decades by purchasing amazing businesses and NOT selling them.

Warren Buffett and many great investors like him are known to buy great businesses and hold them forever. But why do they hold them forever or long long time? It’s because of deferred tax.

In this post, I don’t want to go over Warren Buffett’s investment career as that is no secret anymore. Instead, I would like to talk about deferred tax and how we all can benefit from it too, like great investors of our time have done to become rich.

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Deferred Tax Explained

The deferred tax has many definitions specially in accounting world. I won’t bore you with technical definitions. Instead, we will keep it simple and just understand the concept with help of an example.

Suppose you bought 50 shares of Apple which were selling at $98.5 a piece at a time. Now say in short span of 6 months, the share price of Apple has risen to $150 a piece. So, you will be sitting on a profit of $2,575 { (150 – 98.5) x 50 = 51.5 x 50 = $2,575 }.

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Now let’s look at various things a common investor like you and me do after earning about 50% of profit on investment in short span of time.

1. Sell Immediately – Short Term Capital Gain Tax Incurred

If we sell apple stocks in just 6 months, we will pay something called – short term capital gain tax on the profits which we earned.

Our profit of $2,575 will be added to our income and taxed at same rate as the tax bracket. In other words, if we are in high income tax bracket of 35%, then our profit will be taxed at 35% and we will have to pay $772.5 as tax to IRS/government.

In this case, our take home profit will be:

Net Profit = $2,575 – $772.5 = $1802.5

Instead of 52% of profit that we had earned originally, we only got about 36.5% in our pocket and rest went in short term tax to the government.

Short Term Capital Gain Tax - MakeLivingGood.com

2. Sell after a year – Long Term Capital Gain Tax Incurred

If we hold the stock for 1 year and 1 day before selling it, then we will have to pay long term capital gain tax on the profits which we earned.

Long term capital gain tax rate could be 0%, 15% or 20% depending upon our income for the year.

Considering we are in the highest tax bracket, so the maximum tax that we will have to pay on these profits will be about $515.

As you see, just by holding the investments for a year, we can save $257.5 in tax or pay 33.3% less tax on the profit earned.

In this case, our take home profit will be:

Net Profit = $2,575 – $515 = $2060

Instead of 52% of profit that we had earned originally, we only got about 42% in our pocket and rest went in long term tax to the government.

Long Term Capital Gain Tax - MakeLivingGood.com

If you have to book the profits, then I recommend to do it after a year to save tax unless you know that company behind the stock is in trouble and may not be able to recover.

 

3. Never Sell – Deferred Tax

What if you do not sell any of stocks and just hold them in your portfolio, then you do not have to pay any tax on the profit.

This is because the profit of $2,575 is considered as paper profit and there’s no law in US tax rules today to add paper profits into our income or pay any tax on it.

A paper profit simply means that the profits are not booked yet.

But what is real advantage of deferred tax if we still have to pay tax when profits are booked in future?

Well, by holding the assets for long time, we are letting compound interest work its magic in our favor. More on this next section.

Using deferred tax the great investors have become billionaires including Warren Buffett himself. Warren Buffett is billionaire in paper money. He is not holding much of his assets in cash.

Although his company Berkshire Hathaway maintains a large sum of money in treasury bonds but he does that to park his money until next great investment is found and to provide a cash pool for his insurance business.

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Will Deferred Tax Ever be Paid

The deferred tax is a process to delay the tax payout by not liquidating the assets today. Any time the assets are liquidated, we are liable to pay the tax to the government.

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What great investors do is; they do not sell their assets unless they find a better investment. This keeps tax money work in their favor by compounding the assets over time.

In fact, Warren Buffett has out-smarted everyone and donated 98% of his entire wealth to Bill & Melinda Charity Foundation to avoid even further taxes after he is gone to another world.

There’s something called – Death Tax or more commonly known as Estate Tax. In 2013, US congress passed a bill to impose 40% tax on Estate with more than $5 million in  net worth. In simple terms, if you leave $5 million or more of wealth to your children, then before it could be transferred to your loved ones, US government will take away 40% or $2 million of it in Estate taxes. That’s the law as of today.

But when assets are donated to a charity then there’s no estate tax on it. That’s exactly what Warren Buffett has done with his money. His money will find it’s ways to help those who need it for a long time.

 

What if we need the money today

Any profit earned in our investments, is ours to keep after paying the taxes. So, we can sell it anytime we need some extra money or there’s another interesting opportunity to invest into.

If we book our profits, then we just have to pay the short term capital gain tax if investment period was less than a year or long term capital gain tax if the holding period was more than a year.

Many great investors sell their portfolios from time to time too including Warren Buffett. But they mostly do it when there’s a better investment opportunity they find. For instance, Warren sold his investments in IBM and switched to Apple instead. Today he is the single largest shareholder in Apple company.

 

What Most Investors Actually Do

Common investors like you and me mostly do same thing every time market goes few percentages down or we have earned a good profit on some investment. We panic.

We panic when market goes down and we panic when we earned a good profit on our investment.

This panic leads us to sell the holdings prematurely and book the profits.

 

So, let’s take a look at 2 studies next. First study will explain the effects of actively buying and selling the stocks while second study will show the benefits of holding investments for long time – an example of deferred tax.

 

Effects of Annual Rollover

For this illustration, we will take a hypothetical scenario. Suppose you are a devoted investor who can find great opportunities one after another. There’s no limit on your skills to find at least one investment a year that would yield 15% annual returns.

So, on 1st January if you invest $100,000 then on 31st Dec, your portfolio would grow to $115,000 and it continues for next 20 years.

Every year your investments were generating a fixed 15% return on the investment.

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The only problem is that you worry a lot and panic leading to selling the entire portfolio on 31st December every year. Remember as soon as you sell and book the profit of 15%, there’s a tax due on any profits that you earned in the year. For simplicity sake, say you are in a 20 % tax bracket.

In this scenario, your net profit will be $12000 and tax payout will be $3000 in year one.

In year two, you will invest back $112,000 and earn a profit of $16,800. After paying tax of $3,360 on that, the net profit will be $13,440.

I hope this is clear now and we can look at the full chart for next 20 years of investments.

Impact of tax on investment returns - Deferred tax - MakeLivingGood

This is not bad. Your portfolio reached to $964,629 in value by reinvesting all the profit you earned after paying out the tax in last 20 years. In this case, your net return was about 8.65 times of the initial investment.

Here are some of my favorite books on the topic which I highly recommend you to check.

One Up on Wall Street How to Use What You Already Know to Make Money in the Market - Peter Lynch - MakeLivingGood.com

Warren Buffett The Life, Lessons & Rules For Success - MakeLivingGood

University of Berkshire Hathaway 30 Years of Lessons Learned from Warren Buffett & Charlie Munger at the Annual Shareholders Meeting - MakeLivingGood

The Warren Buffett Way - By Robert G Hagstrom - MakeLivingGood

The Snowball Warren Buffett and the Business of Life by Alice Schroeder - MakeLivingGood

The Little Book of Common Sense Investing The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Books. Big Profits) - MakeLivingGood

 

Deferred Tax Example

Let’s look at a scenario where you were not actively buying or selling the investments.

In this scenario, you are behaving like great value investors who hold their investments for long period of time.

Say in this case as well, you started with $100,000 and earned fixed 15% annual returns on investment for next 20 years.

Basically in year one, you earned paper profits of $15,000 which got fully reinvested for next year.

In year two, investment was grown to $115,000 and net profit earned was $17,250 which is also not booked and carried over to year 3 & so on.

Below the detailed chart for next 20 years of following this approach.

Deferred Tax Portfolio always wins - MakeLivingGood

Wow !! In this case of deferred tax calculator, your portfolio has grown to $1,636,654 which is almost double the size of portfolio in previous case. This is the biggest advantage of deferred tax.

Remember the initial investment was same in both the cases – $100,000 and so was the annual rate of return – 15%. But still in deferred tax example, your portfolio grew by 2 times the other way.

Even after paying the taxes of $327,331 after 20 years in this deferred tax example, your next profit was $1,536,654 which is about $671,000 more than non deferred tax scenario. In net terms, the return was a whopping 15 times the initial investment.

Another important point to understand in scenario 2 is that you didn’t have to bother filing tax on profit earned every year. Instead of doing it 20 times in 20 years, you just did it just once in 20 years which means less stress and less money paid to CA.

There’s also a very critical thing that every investor must learn about investing in stock markets. I highly recommend you to check this post to learn about it – Why is Order of Rate of Return so Important

Why Order of Rate of Return so Important - MakeLivingGood.com

 

 

What are your ideas to grow a portfolio? Which approach do you follow – Rollover or Deferred Tax? Let us discuss it in comments below.

 

Dont Quit - Push Yourself to the Limits - MakeLivingGood

 

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How Deferred Tax Makes You Rich

 

Deferred tax can make you very very rich - MakeLivingGood

 

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