An interest free loan from the tax man

In the immortal words of George Harrison…

“If you drive a car, I’ll tax the street
If you try to sit, I’ll tax your seat
If you get too cold I’ll tax the heat
If you take a walk, I’ll tax your feet

Taxman!
‘Cause I’m the taxman, yeah I’m the taxman”

Old George was pretty dirty at the Tax Man, so i can only assume he didn’t have a very good financial planner or accountant. He evidently also wasn’t an investor, because he failed to write about the interest free loan that the tax man offers to all investors.

You see, income gets taxed every year, but capital gains only get taxed when you sell and lock them in. This means that instead of calling in his dues immediately, the tax man continues to let your wealth compound (along with his… he’s not stupid) year after year. Many years down the track, when your investment has turned into a nice little nest egg, and you decide to sell, the Tax Man will also give you a 50% discount on your CGT bill because you held your investment for >12 months.

Lets have a look at how this works in practice by following the investing journey of 2 identical twin brothers: Turnover Tom & Patient Peter.

Both of the boys decide that investing in shares over the long term would be a good way to grow their wealth, so they each set up a portfolio of growth stocks and contribute $50,000 to kick it off. They both read The time value of money, so they knew how important regular contributions are – as such they commit to contributing $5,000 per year to the portfolio. Each of them achieves a 9% Growth Rate (all capital gains, no dividends for simplicity), and both of them pay tax at a MTR of 37%.

Turnover Tom lacks the calm disposition of his twin brother and he starts to get a bit antsy when his gains exceed 20%. When this happens he locks in his profit (sells), and turns over his portfolio. This happens about once every 24 months. That is to say that he sells the whole portfolio, pays tax on the gains, then reinvests the proceeds into a new set of stocks. (If this seems high to you, consider than in 2013, actively managed funds in Australia had a turnover rate of 85%, ie: 85% of the fund was sold / turned over in one year. In the 2000’s, the rate was more like 160%!).

Turnover Tom’s Investment Journey

Year Start Value Growth Yearly Additions End Value Cap Gains Tax End Val after Tax
1 $50,000 $4,500 $5,000 $59,500 $59,500
2 $59,500 $5,355 $5,000 $69,855 $1,823 $68,032
3 $68,032 $6,123 $5,000 $79,155 $79,155
4 $79,155 $7,124 $5,000 $91,279 $2,451 $88,828
5 $88,828 $7,995 $5,000 $101,822 $101,822
6 $101,822 $9,164 $5,000 $115,986 $3,174 $112,812
7 $112,812 $10,153 $5,000 $127,965 $127,965
8 $127,965 $11,517 $5,000 $144,482 $4,009 $140,473
9 $140,473 $12,643 $5,000 $158,116 $158,116
10 $158,116 $14,230 $5,000 $177,346 $4,972 $172,375
11 $172,375 $15,514 $5,000 $192,888 $192,888
12 $192,888 $17,360 $5,000 $215,248 $6,082 $209,167
13 $209,167 $18,825 $5,000 $232,992 $232,992
14 $232,992 $20,969 $5,000 $258,961 $7,362 $251,599
15 $251,599 $22,644 $5,000 $279,243 $279,243
16 $279,243 $25,132 $5,000 $309,375 $8,839 $300,536
17 $300,536 $27,048 $5,000 $332,585 $332,585
18 $332,585 $29,933 $5,000 $367,517 $10,541 $356,976
19 $356,976 $32,128 $5,000 $394,104 $394,104
20 $394,104 $35,469 $5,000 $434,573 $12,505 $422,067
Totals   $333,825     $61,758  

After 20 years, Turnover Tom has contributed $150,000 out of his own pocket, made $333,825 in capital gains, and paid the tax man $61,758… not a bad effort.

Patient Peter took a slightly different approach though. See, Peter had read a Warren Buffet book or two, and remembered some wise words from the man considered the worlds greatest stock investor… “Our Favourite Holding Period Is Forever.” Peter studied companies rigorously, and chose 5 stocks that he would hold essentially ‘forever’ – only selling if the investment thesis was somehow brought unstuck by a drastic change in the company’s fundamentals. This is what Peter’s 20 year investment journey looks like.

Patient Peter’s Investment Journey

Year Start Value Growth Yearly Additions End Value Cap Gains Tax End Val after Tax
1 $50,000 $4,500 $5,000 $59,500 $59,500
2 $59,500 $5,355 $5,000 $69,855 $69,855
3 $69,855 $6,287 $5,000 $81,142 $81,142
4 $81,142 $7,303 $5,000 $93,445 $93,445
5 $93,445 $8,410 $5,000 $106,855 $106,855
6 $106,855 $9,617 $5,000 $121,472 $121,472
7 $121,472 $10,932 $5,000 $137,404 $137,404
8 $137,404 $12,366 $5,000 $154,771 $154,771
9 $154,771 $13,929 $5,000 $173,700 $173,700
10 $173,700 $15,633 $5,000 $194,333 $194,333
11 $194,333 $17,490 $5,000 $216,823 $216,823
12 $216,823 $19,514 $5,000 $241,337 $241,337
13 $241,337 $21,720 $5,000 $268,057 $268,057
14 $268,057 $24,125 $5,000 $297,182 $297,182
15 $297,182 $26,746 $5,000 $328,929 $328,929
16 $328,929 $29,604 $5,000 $363,532 $363,532
17 $363,532 $32,718 $5,000 $401,250 $401,250
18 $401,250 $36,113 $5,000 $442,363 $442,363
19 $442,363 $39,813 $5,000 $487,175 $487,175
20 $487,175 $43,846 $5,000 $536,021 *$71,414 $464,607
Totals   $386,021     $71,414  

*Assumes shares are sold in parcels over 2 – 3 years so that the capital gains from the sales keep him in the 37% tax bracket (as opposed to tipping him into the 45% bracket if all sold in one hit)

After 20 years, Turnover Tom has contributed $150,000 out of his own pocket, made $386,021 in capital gains, and paid the tax man $71,414. So, he is better off, and the cheeky tax man made an extra $9,656 for his generosity – a win / win.

Here is the quick summary:

Investor Cap Gains Tax Paid Net Value after tax
Turnover Tom  $333,825  $61,758 $422,067
Patient Peter  $386,021  $71,414  $464,607
Difference $52,196 $9,656 $42,540

So there you have it – an extra $42.5k just by not selling! Keeping your portfolio turnover low is basically like an interest free loan from the taxman – plus when you do finally sell, you can feel better about giving him a few extra dollars to go toward schools, roads and all of the other stuff your tax dollars pay for.

Bear in mind that the higher your MTR, the bigger the differences become.
If structured correctly, the tax savings & compounding benefits can also be further enhanced… but perhaps we’ll leave that for another day.

Happy investing.

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