Deferred Taxes: Investment Compounding’s Little Helper

The United States stock market consists of approximately $42 trillion in net worth. Of that, 72% of the wealth is held in what we call taxable accounts. And, once you get past the day traders, the average holding period for a publicly traded investment in the United States in 1.92 years.

Those foundational points are important to keep in mind when you think about the nature of taxation in the United States and one of the most underrecognized benefits of stock ownership—the deferred tax nature of capital gains.

In the United States, it is currently the case that you do not owe taxes on the increase in value of an investment until you sell it. There are logistical and philosophical reasons for why this is the case. Logistically, the value of investments fluctuate so taxation during the middle of your holding period would be difficult to execute. If someone owed taxes, say, based upon any gain that existed on December 31st of each year, it would raise the question: How would you handle gains in year 1 followed by losses in year 2? Would unrealized losses come with a benefit? Would taxes at the end of each year serve as a high-water barrier where no further taxes accrue at year end until the barrier is crossed?

Secondly, and perhaps more importantly, there are philosophical reasons for delayed taxation. One, the U.S. tax policy provides benefits that induce long-term business ownership because it benefits the integrity of business. By rewarding shareholders for sticking around, you will encourage the creation of an investor class that cares about the sustainability of business operations. All told, someone who is going to care about something ten years from now is going to engage in better behavior regarding their interactions with “Investment X” than someone who is only going to care about an investment for a month.

Also, paying taxes requires money. By delaying taxes until an investment is sold, and having only the capital gains being subject to the tax, there is an assurance that the taxation is being directed at something where a surplus was created. If unrealized gains were subject to taxes, an investor would have to come up with money from somewhere else to pay the taxes or else sell some portion of a stock that increased in value each year to pay off the taxes.

And finally, the country benefits from delayed taxation on capital gains because allowing the investment to grow means that there will be a greater bounty from which to tax when the date of the investment sale eventually arrives.

It is this mutually beneficial point that is worthy of additional examination. For assets held more than a year, the capital gains tax rate is 20% (although a 3.8% net investment tax can also apply once $250,000 in adjusted gross income is reached for a married couple or $200,000 for an individual). Delaying the payment of this capital gains tax is a significant advantage that naturally accompanies any investment.

Imagine you owned shares of Microsoft that increased in value from $10,000 to $30,000. If you decide to sell that for whatever reason, you owe the government $4,000 and then you are only working with $26,000 going forward. Now, picture someone in the identical situation who decides to hold onto Microsoft stock, and in the following year, both Microsoft stock and the seller manage to achieve a 10% gain on their investments.

The person with $26,000 in capital gains $2,600 to $28,600 and is carrying an unrealized tax liability of $520 for $28,080 in final value. For someone with $30,000 who then achieved 10% returns, the account would gain $3,000 for a pre-tax value of $33,000. The unrealized tax burden on the $23,000 gain would be $4,600 for a final value of $28,400. Even though both investors were compounding at the exact same rate, the latter has $320 in extra net wealth due not exchanging compounders.

And that is just the amount of the benefit for one year. This benefit continues to accrue on all investments in one’s entire taxable portfolio over a lifetime compounding.

As a result, buy and holders in taxable accounts go through their lives with an advantage. For whatever amount of your taxable gain remains unrealized, it continues to compound for you, and since tax rates are currently 20%, you get to keep 80% of the gain on the amount of taxes you owe but do not have to pay as a result of not selling. Charlie Munger once said the nature of deferred taxation is so significant that investors who refuse to sell their stocks are almost guaranteed to outperform over a lifetime on a net basis just by availing themselves of this portion of the tax code.   

This is an important advantage that, say, “blue-chip investing” carries over “value investing.” If you buy the best companies in an industry, you do not have to exchange compounders and you can avail yourself of deferred taxation. If you only buy a stock because it is cheap, you give up the deferred taxation advantage when you sell at fair value and then you must outperform the blue-chip investor just to make up the additional taxes that you had to pay. Deferred taxation in taxable accounts should be part of your pre-investment planning as an advantage to harness.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!

One thought on “Deferred Taxes: Investment Compounding’s Little Helper

  1. Roberto Alvarez says:

    Thank you for another great article. Tax are so important that in my coutry we get taxed becuase of inflation even though in USD your assets don´t move. This is becuase we have a tax every year over someone´s assets holdings during a year. A tax that was born ¨for the rich people¨ but within a few years and due to inflation and politics not modifiying taxable scales everybody sooner or later was considered ¨rich¨ and was forced to pay. Oh and of course the tax was born as transitory and due to hard times but then it seems hard times never ended becuase it is here every year with us. Taxes are the worst enemies for investments and businesses and my country is the best example for that. A country with rich resources and poor people (except from politicians) and a market that if you invest for the long run you loose money every time, the only thing that works is try to time the market the best you can. Incredible but true.
    Excuse my writing and regards from a conservative income investor fan from Argentina.

Leave a Reply