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Summary As Charlie Munger says, a deferred tax liability is like an interest-free “loan” from the government. The magic of compounding is best illustrated with a high return investment held over a large number of years. Examples help illustrate the importance of the timing of tax payments. Introduction Tax laws in the U.S. are setup such that patient investors can be rewarded. Warren Buffett of Berkshire Hathaway (NYSE: BRK.A ) illustrates this in an example in his 1989 letter to shareholders. We’ve added a few more examples that show what happens when the number of years and the rate of return are different. Examples Warren Buffett uses an extreme example in the 1989 letter to shareholders to show how tax laws favor investors who hold for the long term as opposed to switching investments yearly: Imagine that Berkshire had only $1, which we put in a security that doubled by year-end and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during the 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000. Summing up, we have the following: Starting Investment: $1 Length: 20 years Return: 100% Tax Rate: 34% Yearly Switch Total: $25,250 No Switch Total: $692,000 This is a powerful example but it may not fully register with everyone. For one thing, most of us won’t find an investment that doubles every year for 20 years straight. If we do then we’ll put more than $1 into it. We’ll use this first example as a template for more examples where these 2 variables are more realistic. As for the 34% tax rate, we’ll leave that alone. It is fine for companies. When it comes to individuals, folks in some states pay less and folks in others pay a little more. Living in California, my cumulative tax rate is actually higher than 34% because it’s about 23.8% federal plus about 13.3% state. Long-term capital gains apply to assets held over a year so in these examples the “Yearly Switch” investor might actually have to switch after a year and 1 day. Like the first example above, we’ll ignore transaction costs. Over the years Berkshire let the timing of tax payments work to its advantage with big investments like American Express (NYSE: AXP ), Coca-Cola (NYSE: KO ) and Wells Fargo (NYSE: WFC ). However, showing the specifics here could get a bit messy. Looking at Coca-Cola for instance, the letters to shareholders show different share amounts in 1988, 1989 and 1994. The 1989 letter shows most of the position was in place by the end of that year (373.6 million out of today’s 400 million shares adjusted for splits) but showing the yearly switch and no switch differences isn’t as straightforward as other examples. Suppose an investor decided to buy 1 share of Berkshire Hathaway on June 30, 2005, and hold it for 10 years until June 30, 2015. It went from $83,500 to $204,850 per share during that time: Starting Investment: $83,500 Length: 10 years Return: 9.3893% Tax Rate: 34% Yearly Switch Total: $152,337 No Switch Total: $163,591 (204,850 – .34*(204,850-83,500)) Our investor made over $10,000 more after taxes with the patient No Switch strategy as opposed to the more frenzied Yearly Switch strategy. Let’s look at another example with a higher rate of return and a greater number of years than the last one. Suppose an investor decided to buy 1 share of Berkshire Hathaway on June 30, 1985, (technically just before the closing bell on June 28) and hold it for 30 years until June 30, 2015. It went from $2,150 to $204,850 per share during that time. Starting Investment: $2,150 Length: 30 years Return: 16.4036% Tax Rate: 34% Yearly Switch Total: $46,960 No Switch Total: $135,930 (204,850 – .34*(204,850-2,150)) This time the patient No Switch approach made a huge difference as it ends up with almost 3 times as much money after taxes as the more frenzied Yearly Switch approach. Closing Thoughts We see that being patient and not jumping from investment to investment has great rewards when the rate of return is high and the number of years is large. Those that bash Warren should note that the government makes more money as well in the long run when Berkshire defers taxes. Sources Berkshire Hathaway Letters to Shareholders MarketWatch Historical Stock Prices Yahoo Finance Historical Stock Prices Disclosure: I am/we are long BRK.A, BRK.B, KO, WFC. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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