BULLS & BEARS: How compounding, taxes affect investment returns

Investors who purchase individual securities in taxable accounts have a great deal of control over their tax situation-taxes are due only when the investment is sold and gains are realized. Those who wish to monitor their potential tax liability could maintain an “unrealized tax liability account” on their investment ledger that tracks the tax due if the investment were sold.

Anyone who has held securities for decades is aware of the power of delaying the tax man. A single investment, held for years and that compounds at an attractive rate of return, is an excellent way to build wealth and defer taxes.

Warren Buffett illustrated the power of long-term tax deferral in Berkshire Hathaway’s 1993 annual report by telling an entertaining anecdote from the comic strip “Li’l Abner”.

Buffett relates that in one particular strip, Abner had a desire for the temptress Appassionatta Van Climax. Unfortunately, she was interested only in millionaires, and Abner had only a single silver dollar. Seeking advice from Old Man Mose, the sage in the town of Dogpatch, he was told to double his money 20 times and he would win her over (1, 2, 4, 8 … 1,048,576).

The next frame of the strip continues with Abner plunking his dollar into a slot machine and hitting the jackpot as money spilled onto the floor-whereby Abner, meticulously following Mose’s advice, picked up $2 and moved on to find his next double.

Aside from Abner’s gaffe, Buffett notes that when Mose was passing out his wealthgathering advice, he forgot about taxes. For had Abner been subject to a federal tax rate of, say, 35 percent, and managed one double annually, he would have accumulated only $22,370 after 20 years. And he would have needed another 7-1/2 years of doubling to make his million.

Instead, Buffett queries what would have happened if Abner had put his dollar into a single investment and held it until it doubled the same 27.5 times. In this case, Abner would have realized $200 million pretax, and after paying $70 million of tax in the final year, Abner’s net proceeds would have amounted to $130 million.

Buffett’s moral of the story is that, “Taxpaying investors end up with an immensely greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.”

Other things to consider: Tax-paying mutual-fund investors lose a considerable amount of control over their tax timing. When investing in mutual funds for the long term, it is imperative to identify a fund manager who buys and sells infrequently (low turnover). The patient investor not only postpones his tax liability, but also minimizes commissions-a frictional cost that acts like a tax.

Likewise, most long-term investors also have figured out they have no need to pay the suffocating fees alternative investment funds charge. They understand that annual 2-percent management fees and 20-percent overrides on gains act identically to a punishing annual tax on their wealth accumulation.

When the subject of taxes arises, many advisers will counsel that you should never let tax issues control an investment decision. Perhaps, but as the math suggests, taxes have a major influence on wealth accumulation over the long term.