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CHAPTER 3.5
SPEED IT UP: 3. REDUCE FEES AND TAXES (AND INVEST THE DIFFERENCE)
We have what it takes to take what you have.
—SUGGESTED IRS MOTTO
“You must pay taxes. But there’s no law that says you gotta leave a tip.”
—MORGAN STANLEY ADVERTISEMENT
So now you’re rocking and rolling—you’re speeding up your path to financial freedom by saving more and earning more! What’s left? Doesn’t that cover it? Actually, no. You now know as an insider that it’s not what you earn that matters, it’s what you keep. Our third strategy for speeding things up is to get more money out of your investments by reducing your fees and taxes, and reinvesting the difference.
Remember our three childhood friends from chapter 2.2, “Myth 2: ‘Our Fees? They’re a Small Price to Pay!’ ”? They all invested $100,000 at the age of 35 and earned a 7% return on their investment. But each one was subject to a different set of fees—and the difference between the 1%, 2%, and 3% fees came out to hundreds of thousands of dollars. Taylor, who paid just 1% in fees, accumulated almost twice as much money as her friend Jason, who paid 3% in fees. Her investment grew to $574,349, while he was left with only $324,340!
Remember, those hidden fees on mutual funds average an astronomical 3.17%. The difference between owning high-cost, fee-laden mutual funds versus low-cost index funds could literally cost you a decade’s worth of your life’s work—talk about slowing you down on your path to Financial Freedom! And to add insult to injury, studies show that the high fees that come along with those mutual funds almost never lead to increased performance.
So stay away from excessive fees. Run for the hills. Find low-cost index funds to invest in and heed the warning of Jack Bogle, who showed us that paying through-the-nose fees can eat up as much as 50% to 70% of your future nest egg! The mantra is simple: take the money you save on fees and reinvest it for compounded growth. This strategy is another fast lane to freedom.
And what about an even bigger bite of your savings? Do you know what the single largest bite to come out of your nest egg is? Survey says: taxes!
Over the course of our lives, the average American pays more than half of his or her income to an assortment of taxes: income tax, property tax, sales tax, tax at the pump, and so on. (According to what many experts estimate, currently, that’s 54.25 cents per dollar.) Good ol’ Uncle Sam. And we’re not done yet.
After 54.25% has been lopped off for the tax man, you can also say good-bye to another 17.25% of each dollar you earn in interest and fees. Got a car, a house, any credit card or student loan debt? In April 2014 the average US household had credit card debt of over $15,000; student loan debt of over $33,000; and mortgage debt of over $150,000. As a nation, we are up to our eyeballs in debt.
The fact is, on average, approximately one-third of the income you have left after taxes will be spent on paying down interest!
That leaves you with (drumroll, please) a whopping 28.5% of your hard-earned income left over to pay for everything else in life: food, clothing, shelter, education, health care, travel, entertainment, and anything else you happen to stumble upon at the mall or on Amazon! Plus, out of this same number, you have to find a way to save and invest for Financial Freedom, or at least some form of retirement income!
Becoming more efficient with your taxes is one way to get back some of that 54% you’ve given away. Keep more of your hard-earned income, and that’s money that you could invest and compound to achieve your vision of Financial Freedom quicker.
In fact, if you’re a high-income earner, living in a high-income state like California (as I used to), your total tax bill (including income, investment, payroll, Obamacare, and Social Security) clocks in at 62%. Which means that unless you have an efficient tax strategy, you get to keep only 38 cents out of every dollar you earn.
There’s no good reason to pay more than you have to—in fact, it’s your right as an American not to pay more than you have to. As Billings Learned Hand, one of the most influential judges of all time, stated: Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.
I follow Judge Hand’s wisdom. I don’t believe in paying any more than I absolutely have to, and neither should you. I continually look for legal, ethical ways to lower my tax bill, and I do my best to make use of government initiatives that allow me to build my nest egg in a tax-free environment. I learned from those I interviewed that tax efficiency is one of the most direct pathways to shorten the time it takes to get from where you are now to where you want to be financially.
I am proud to be paying taxes in the United States. The only thing is, I could be just as proud for half of the money.
—ARTHUR GODFREY
Let’s be clear: I’m a patriot. I love America. I am one of millions of examples of the American Dream, and I’m happy (well, perhaps not happy, but proud) to pay my taxes. Yet I pay millions of dollars in taxes every year. My tax bill is more than I ever thought I’d earn in a lifetime, much less in a year. But I know from Yale’s David Swensen that there are only three forces that can help you achieve the greatest returns: 1. Asset allocation,
Diversification,
Tax efficiency.
It helps, of course, that David runs a nonprofit organization, but for the rest of us, even with current tax laws, there are ways to maximize investment returns and minimize your tax bill.
Money Power Principle 4. Tax efficiency is one of the simplest ways to continuously increase the real returns on your portfolio. Tax efficiency equals faster financial freedom.
(Reader alert: If your brain is going to blur as I talk about taxes, I get it! Then simply jump immediately to the next chapter so you don’t lose momentum. But be sure to schedule a time to sit down with your fiduciary and/or a tax expert to learn how to be most tax efficient with your investments. If you’re willing to go for it, the next four pages offer some simple tax distinctions that, when understood, will allow you to keep more of your invested income and achieve your financial dreams faster.) PICK YOUR TAX!
What if you realized that a small amount of tax knowledge could save you from needlessly paying 30% of what you earned to the tax man? How much faster could you achieve your financial goals?
You need to pay close attention to three types of taxes as an investor:
- Ordinary Income Tax.
As stated, if you’re a high-income earner, your combined federal and state income taxes are nearing or exceeding 50%.
- Long-Term Capital Gains.
This is a tax on investments, which is only 20% if you hold your investment for longer than one year before you sell.
- Short-Term Capital Gains.
This is a tax on investment gains if the investment is sold before you have held it for a minimum of one year. Today the rates are currently the same as ordinary income taxes. Ouch!
Now that you know the power of compounding, I’m sure you realize how compounding your growth after taking a 50% tax bite as opposed to a 20% tax bite can mean the difference between arriving at your financial goals a decade early or never getting there at all.
Want to understand the real impact of this?
• If you’re getting an 8% gross return on your mutual fund, you’re paying as much as 3% in fees on average—let’s call it 2%, conservatively.
• So now your 8% return nets you 6% after fees. But we’re not done yet.
• If you’re a high-income earner from California or New York with a 50% federal and state ordinary income tax, you’re left with closer to 3% on your investment after all these fees and taxes.
Remember you get to spend only what you keep; if you invest with a 3% net return, it takes 24 years to double your money.
If you made the same investment in an index fund, your 8% return would have fees in the range of 10 to 50 basis points (or 0.10% to 0.50%). We’ll go for the larger number just to be conservative. That means you have a 7.5% return (8% - 0.5% = 7.5%), but since the index is not trading constantly, you defer all tax, and so your net return for the year is 7.5%. That means you can reinvest those returns and tap into the incredible power of compounding without the tax man interfering.
If you conscientiously manage your investments for tax efficiency, your 7.5% allows you to double your investments in 9.6 years instead of 24 years! Now do you see the importance of both tax and fee efficiency?
So how do you lower your tax bill and keep more of your earnings so you can compound your investments and achieve your idea of Financial Freedom faster?
• Make sure that wherever possible, you invest in a way that allows you to defer your taxes (401[k], IRA, annuity, defined benefit plan) so that you compound tax free and pay tax only at the time you sell the investment. Or set up a future tax-free environment by growing your investments in a Roth.
• When you do sell any investment held outside of a tax-deferred account (like an IRA), make sure you hold for a minimum of a year and a day in order to qualify for the lower long-term capital gains rate (again, at the time of this writing the rate is 20%).
ONE MORE THING: BEWARE OF MUTUAL FUNDS
For most people, a home sale is usually a once- or twice-a-decade thing, and your accountant or tax expert can easily explain how to do this most tax-efficiently. But let’s take a look at mutual funds. Do you know what those mutual fund managers of yours are doing every day? They’re trading. They are buying and selling stocks and bonds on a daily, monthly, or quarterly basis. This is what the industry calls “turnover.” According to Charlie Farrell of CBS MarketWatch, “So although their marketing material encourages investors to buy and hold, the managers certainly don’t practice what they preach. What they really mean is buy and hold their mutual fund, while they trade your retirement savings like crazy.” Experts say that the vast majority of mutual funds do not hold on to their investments for a full year. Why else would you buy them other than hoping they can trade their way to better performance? And you know what that means? Unless you’re holding all of your mutual funds inside your 401(k), you’re typically paying ordinary income taxes on any gains.10 In short, there’s a good chance you’re being charged 35%, 45%, or up to 50% or more in income tax, depending on what state you live in and your income level. All this tax, and you didn’t even sell your mutual fund! So instead of keeping all your gains and having them continue to compound tax deferred, you are taking a devastating hit to your compounding ability that is completely avoidable if you understand tax efficiency.
Even if you’ve maxed out your 401(k) and IRA, you can still make investments in a form that allows you to defer taxes. Index funds do not constantly trade individual companies; they usually hold a fixed basket of companies that changes only if the index that the fund tracks actually changes—which is rare.
As a result, if you’re investing in an index long term, you’re not taking the tax bite each year; instead, you’re deferring the taxes, since you haven’t sold anything. That money can remain in the fund and continue to compound earnings to its owner: you!
Your fiduciary or a great tax expert can help you understand all the ways you can produce more net growth in your Freedom Fund so that your compounding process is maximized. Remember, this can save you years or even decades!
And finally, in section 5, there is a strategy that you’ll learn about in the “Secrets of the Ultrawealthy” chapter that you can use, too: an IRS-approved method that will make a huge difference by allowing you to compound your investments and help you keep your nest egg tax free. This could allow you to achieve your financial goals up to 25% to 50% faster without taking any greater investment risks!
Have I got your attention? I hope so. Because it’s your money and it’s your life! Don’t let anyone take it or waste it! So you now have three fast-track strategies to speed up the pace and win the money game: 1. Save more and invest the difference.
Earn more (add value) and invest the difference.
Reduce fees and taxes and invest the difference.
Now it’s time to turn on the juice and take a quick look at some of the ways you can increase what your investments earn. . . .
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