Reason #4: Letting the Tax Tail Wag the Dog!

Good Morning Relaxing Retirement Member,

A few weeks ago, I revealed an incredible statistic reported by Dalbar, Inc., a Boston based research firm.

They revealed the fact that while the S&P 500 Stock Market index earned 8.25% per year over the last 20 years, the average stock mutual fund investor earned only 1.87%!

That’s an average of 77% less return than the market index produced.

77% less each and every year!

Since then, I’ve revealed three big reasons why this is the case.

In this Retirement Coach Strategy of the Week, I’m going to reveal the 4th big reason why this huge disparity exists.

Letting the Tax Tail Wag the Dog

Let me explain what I mean by walking you thru a real life Case Study of an employee of GE:

  • Charlie was an employee of GE for 42 years
  • He purchased GE stock shares through payroll deduction during entire career
  • As a result of purchases and stock splits, when Charlie retired in January 2002, he owned 27,000 shares!
  • At $41 per share, the value of his shares was $1,100,000
  • What’s important to note is that these GE shares represented 63% of Charlie’s investments!
  • The next important fact was that his cost basis in the GE shares (i.e. what he paid for them) only $50,000

Question #1 to Contemplate: Is it a good idea for Charlie to have 63% of his investments tied up in any one stock?
Question #2: If Charlie had $1.1 million in cash today, should he buy $1.1 million of GE stock?
Question #3: If the answer is NO, why would Charlie then hold on to them and not diversify?

The Answer: Taxes!

Because his cost basis was only $50,000, if he sold the shares back in 2002, he would have paid $210,000 in capital gains taxes, and walked away with $890,000.

Charlie’s focus was on the $210,000 he had to pay to free up the money and diversify.

He would have been far better off focusing on the fact that he had to part with 20% in order to free up the other 80%. It sounds a lot better.

So, what did Charlie do?

Like the overwhelming majority of people, Charlie hung on to the GE shares to avoid paying any taxes.

Now, let’s take a look ahead to today and see how good of an idea that was.

  • If Charlie sold the shares back in 2002, paid the tax, and reinvested the remaining $890,000 in a generic S&P 500 Index Fund like Vanguard’s, from January 2002 to January 2010, the value would have grown to approximately $1,057,000.
  • However, he would then have to pay capital gains taxes again of $33,000, so in January of 2010, he would have ended up with $1,023,000 after taxes if he had sold his shares back in 2002, paid the taxes, and reinvested in a basic diversified equity index fund instead.

Let’s now look at where Charlie is now since he didn’t sell his GE shares back in 2002 in order to avoid paying taxes.

  • If he continued to hold GE shares, including reinvesting the dividends, his shares, in January 2010, his shares are worth $540,300.

To recap, had he sold, paid the taxes, and reinvested, he would have had $1,023,600 (the after tax proceeds of the 500 Index fund shares sold in January 2010).

However, because he let taxes drive his investment decision back in 2002, today he only has $540,300 (the value of his GE shares today).

The Penalty for Letting the Tax Tail Wag the Dog

If you do the math, that’s $483,300 that Charlie lost because he “Let The Tax Tail Wag The Dog” instead of using sound, rational judgment.

Charlie focused on the dollar amount that he had to pay in taxes which was over $200,000. I agree that’s no fun (and the fairness of it is another topic we won’t touch today).

However, by focusing on that dollar cost, he drastically increased his risk and lost more than twice as much!

This is a classic example that I’ve personally witnessed time and time again. And, it’s one of the great lessons of why the average investor not only doesn’t beat market averages, but instead, as statistics have now shown, earns 77% LESS.

Stay out of the trap! Evaluate the tax consequences and the investment consequence simultaneously!

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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