The Investment Scientist

Before we discuss the cost of advanced taxation (or the benefit of deferred taxation,) I need to first introduce the concept of time value of money. That is to say, $100 a year from now is different from $100 today.

Let’s say I owe $100 in taxes due to be paid next year, but for some tricky reason, the IRS wants me to pay that now. How costly is this advanced taxation to me? Well, if I didn’t have to pay the tax today, I could invest the $100. Let’s also assume the return is 8%, so by next year, I would  have had $108. I could pay the $100 tax and get to keep the remaining $8. If I have to pay $100 today, I forgo that $8. That’s the cost of advanced taxation. 

With this concept established, now let me run an experiment with the following assumptions:

• The investment cycle is 20 years.
• The investment return per year is 8%.
• Of  the 8%, 2% is dividend distributions that are taxed at a 50% marginal income tax rate.
• The remaining 6% is the capital gain. Capital gain distributions (“CGD”) range from 0% to 5%, and they are taxed at the long-term capital gain tax rate of 20%.

The study is about how changing the CGD rate affects the investor’s tax liability as a percentage of initial principal investment.

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The following is a hypothetical but highly realistic example of mutual fund advanced taxation. You invest $100,000 in a stock mutual fund on Dec 20th. You get a distribution of $10,000 on Dec 23rd. The distribution is reinvested. When you go check your account balance at year-end, the account balance has gone down a little to $99,950. No big deal.

In January, you get a 1099-DIV form from the mutual fund company showing you have dividend income of $2,000 and capital gains of $8000. (They add up to $10,000). You have to pay taxes on those! You jump from your chair: “What! I lost money in the investment, and I have to pay taxes on income and gains I don’t see?! What gives?”

It turns out that mutual funds are required by law to distribute any dividend incomes and all net capital gains by year-end. Usually, they have a record date in December. If you are a fund-holder on record at that time, you will receive the distributions. Most mutual funds have their record dates fall between December 10 and December 20.  Read the rest of this entry »