Think Bigger

LESSON 37We Actually Live in an After-Tax World

Perhaps the most profound insight about investing (while alive), and estate planning (for later), is that most of our thinking relates to pre-tax considerations when, in fact, the net results realized are ultimately after-tax. Comparing two investments or strategies based on their pre-tax expected returns seems reasonable, but in an incredibly important number of ways, that analysis obscures what the actual comparable net results will really be. The tax impact on one investment might be dramatically different from the impact on the other, and what looks like a winning strategy in a pre-tax world ends up being the losing strategy in the after-tax world we actually live in.

Not only do relative tax rates come into play, but also the timing of when taxes are payable. The concept is so fundamental that a single example should illustrate it: Let’s say that two investments have expected lives of 20 years. The first is a $10,000 bond that pays 8 percent interest each year. The interest is taxed at a combined 50 percent federal and state income tax rate. Assuming the interest can be reinvested at the same rate, the $10,000 investment grows to $21,900 after taxes. In the second case the $10,000 is invested in a stock that grows by 7 percent each year and is sold at the end of the twentieth year. The stock grows to $38,700. After paying the various taxes related to a capital gain, which total around 35 percent, the investor nets $28,650. ...