The use of deferred taxes is one of the ways to increase long-term investment returns. This approach is considered a portfolio management technique that can help improve long-term performance. The main advantage of this method lies in the way the tax system in the United States is designed. It creates a natural advantage for the passive plan over the years, and the compounding works its magic.
Investing in a Low-Cost Basis as an Interest-Free Loan
Imagine that you bought 10,000 shares of AutoZone 15 years ago at a price of $26.00 per share for a total cost of $260,000. You placed the stock certificates in a safe and haven’t looked at them since. You check the news and find that the stock closed on Friday at $439.66. The value of your 10,000 shares is now $4,396,600. No dividends were paid during the holding period.
You are now sitting on $4,396,600, of which $260,000 represents your original investment (“the basis”), and $4,136,600 is your unrealized capital gains. If you live in the Kansas City area and decide to sell your shares, you would owe a 15% tax to the federal government and a 6% tax to the state of Missouri. Your total taxes would amount to 21%. Therefore, from the $4,136,600 in unrealized gains, $868,686 is the amount you will have to pay to cash out those shares.
The famous investor Warren Buffett pointed out that a person holding stocks for the long term should consider the $868,686 as an interest-free loan from the federal and state government. Unlike other debts, your assets are working for you, but you have no monthly payments. More importantly, there are no interest expenses, and you can choose when the bill is due. As long as you continue to hold your stocks, you have plenty of free money working for you. It will go to pay taxes and will not come back to you if you decide to sell your AutoZone shares.
If AutoZone grows at an average rate of 10% each year over the next decade, in the first year alone, you will accumulate nearly $87,000 in market wealth that you would not have been able to access without that. This will happen simply because the $868,686 of money that was not paid in taxes will remain invested instead of being paid as taxes.
The longer you allow this trend to continue, the more powerful you become in the wealth creation cycle that positions you as a “buy and hold” investor significantly ahead of the day trader.
Holding an Overvalued Asset Instead of Exchanging It for a Lower-Valued Asset
This is one of the main reasons why you don’t see wealthy individuals or successful portfolio managers selling just one stock to move to another slightly better stock.
Suppose you own $1,000,000 worth of PepsiCo shares that you have accumulated over decades, and your cost basis is $100,000. This means that $900,000 represents unrealized capital gains. In your case, $189,000 of deferred taxes would be responsible for offsetting the liability on your balance sheet. Your PepsiCo shares are trading at 20 times earnings, or a dividend yield of 5%. This means that your share of PepsiCo’s earnings each year is $50,000.
Now imagine that Coca-Cola is trading at 17 times earnings, with the same expected growth rate and dividend payout. This translates to a dividend yield of 5.88%, which is 17.6% higher than the yield paid by PepsiCo relatively and 0.88% higher than the absolute yield. If the entire $1,000,000 of your money is invested in Coca-Cola, your share of the net earnings would be $58,800. Adding $8,800 to the earnings is not a trivial amount.
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Learn now, it’s not that simple. Let’s do the math to see what happens if you decide to make the switch.
Let’s assume you’ve sold your PepsiCo shares and saw $1,000,000 cash in your brokerage account. Immediately, this will trigger a tax bill of $189,000 to the U.S. government and state, leaving you with $811,000. You then invest this $811,000 in Coca-Cola shares with a dividend yield of 5.88%, meaning your share of the profits is $47,687 annually. Though it may seem odd, you’ve actually lost $2,313 in net profits, or 4.6% of what you were generating indirectly each year, despite purchasing an asset with a higher yield.
How can this happen? A capital loss when triggering deferred capital gains tax means you’ve put less of your money to work for you. In this scenario, the hit was enough to outweigh the benefit of the higher dividend yield on the cheaper stock. Therefore, the moral of the story is: once you’ve earned some wealth by building your portfolio with clear intent and care, moving between stocks in a taxable account can be a costly step that impacts post-tax outcomes. This is why experienced wealth managers focus on the metric that matters: the amount of risk-adjusted surplus generated each year, after taxes and inflation, from your investments. This is how people become wealthy from their investments.
In the end, deferred taxes are a form of leverage that lacks the downsides found in other types of leverage. It is a power you should strive to exploit to shape your long-term strategy to take advantage of its effects.
Source: https://www.thebalancemoney.com/using-deferred-taxes-to-increase-your-investment-returns-357395
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