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.

The yellow bar in the chart shows the total tax owed relative to the CGD rate. If the CGD is 2%, then the present value of total tax owed over the next twenty years would amount to 22.5% of the initial investment. If your initial investment is $1mm, the present value of total tax owed in the next twenty year is $225,000! Needless to say, you want this number to be as small as possible, to do that, all things equal, you want to pick a mutual fund that has a lower CGD rate.

Total tax owed is further split into two parts, the red bar represents tax paid over the 20-year life cycle, the blue bar represents tax deferred at the end of the 20th year. You want the red bar to be as short as possible and the blue bar to be as tall as possible.  In the following situations you may not need to pay the deferred tax (blue bar.)

1. You die, your children inherit you money and they get a basis step-up.
2. You donate the investment to charity, and your deferred tax liability gets wiped clean.

Again, as you can see from the chart, the lower the CGD rate, the shorter the red bar and the taller the blue bar.

Most normal mutual funds have a CGD rate between 2% to 3%, If the CGD rate can be reduced to 0%, the present value of taxes paid drops by more than half, and the present value of taxes deferred nearly doubles. It is thus tremendously valuable to choose mutual funds with a low CGD rate.

For example, if you initial investment is $1mm, mutual fund A you invested in has a CGD rate of 3%, then the present value of all taxes paid over the next twenty years is $184k; the present value of tax deferred is $59k. However, if you invest in mutual fund B that has a CGD rate of 0%, then the present value of all taxes paid over the next twenty years is $74,000, the present value of tax deferred is $11.8k.

In my next article I will write about what drives a mutual fund’s CGD rate.

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