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Tax Deferral Equals Tax Reduction
Posted by: Value Study (IP Logged)
Date: October 20, 2013 12:09AM
In this article, I would like to discuss how tax deferral is equivalent to tax reduction.
To preface this discussion, I would like to insert a quote from Mr. Warren Buffett. In a letter dated January 18, 1965 to his limited partners in Buffett Partnership, Ltd., Mr. Buffett states:
So, up front, let’s acknowledge that tax reduction is not the key ingredient in investment success -- the key ingredient is owning the most attractive investments at current prices. However, tax reduction “may be a factor to be considered” when attempting to maximize after-tax returns. Thus, tax reduction does merit some discussion and analysis – and that’s the purpose of this article. With that understanding in place, let’s talk about tax deferral and tax reduction.
Horizon Kinetics, in its 2013 1st quarter market commentary, addresses how Warren Buffett has deferred taxes in Berkshire Hathaway:
Quote:In order to visualize the tax-reduction example described in the last paragraph of the Horizon Kinetics excerpt, I created an interactive tool that allows a user to input certain investment and tax assumptions and obtain associated results. A snapshot of this interactive tool is shown below.
As you can see, the math that Horizon Kinetics uses is correct. The investment and tax assumptions that Horizon Kinetics uses leads to: 1) An after tax amount of $791,703.45 and effective annual tax rate of 9.2% when the investment is sold after 20 years and taxes are paid on the gain (at long-term capital gains rates), and 2) An after tax amount of $625,476.62 and effective annual tax rate of 20% when the investment is sold each year, taxes are paid on the gain (at the long-term capital gains rate of 20%), and then the money is reinvested at the annual pre-tax investment return of 12%.
To further flesh out this tax deferral principle, I decided to graph the effective annual tax rate versus holding period for different levels of pre-tax return. Please note that in the graph legend, Strategy A refers to holding an investment until it is sold at the end of the time period – at which point taxes are paid on the gain. In this same legend, Strategy B refers to selling an investment each year, paying the associated taxes (at the long-term capital gains rate), and reinvesting the after-tax proceeds at the specified annual pre-tax investment return.
As should be fairly intuitive, the effective annual tax rate for Strategy B (for all pre-tax returns and time periods) will equal the long-term capital gains rate because the investment is sold every year.
However, the effective annual tax rate for Strategy A varies according to pre-tax return and holding period. In the case of Strategy A (i.e., buying and holding an investment for more than 1 year), the effective annual tax rate decreases as the holding time period increases. Additionally, the effective annual tax rate is lower when pre-tax returns are higher. Also, interestingly enough, for pre-tax returns that are 10% per year or higher, it appears that most of the decrease in effective annual tax rate (i.e., the benefit) comes in the first 20 years or so.
Obviously, this tax deferral information alone will not make us better investors. For that, we need to scour the investment world and find the best risk-adjusted investment opportunities. But it does show that deferring taxes can lead to much lower effective annual tax rates.
A tax deferral strategy can make a lot of sense if one is invested in an asset that can internally compound value at a satisfactory rate over a long period of time. In those situations, tax deferral can equal significant tax reduction, and lead to much larger after-tax investment results.
Stocks Discussed: BRK.A, BRK.B,
Re Tax Deferral Equals Tax Reduction
Posted by: vgm (IP Logged)
Date: October 21, 2013 07:34AM
An excellent reminder of the power of deferred taxes! Deferred personal tax in tandem with tax-efficient management (Buffett, Malone, etc) is an awesome combination for an investor.
The HK commentary is brilliant. I must read more of them.
Stocks Discussed: BRK.A, BRK.B,