SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

The Magic of Compounding, and the Tyranny of Taxes


Today I want to talk about something that is often ignored, yet has a very large impact on the net performance of our trading and investing: Taxes. To illustrate the importance, I often like to point out both the power of compounding and the impact of taxes with a simple example.  

If you could double a dollar every year, for 20 years, how much do you think it would be worth? Before glancing down, I'd really encourage you to take a guess first...So for example, I'm saying:

 

$1

End of year 1. $2

End of year 2. $4

End of year 3. $8

 

And so on, for a total of 20 years...Now go ahead and stop, without cheating, and make your guess. Doing this with people for more than a decade now, I get answers that have a wide range, but are consistently below the actual result. And usually not even close. So here we go:

 

  $1
1 $2
2 $4
3 $8
4 $16
5 $32
6 $64
7 $128
8 $256
9 $512
10 $1,024
11 $2,048
12 $4,096
13 $8,192
14 $16,384
15 $32,768
16 $65,536
17 $131,072
18 $262,144
19 $524,288
20 $1,048,576

 

Is your mind blown? Don't feel bad if you guessed something that wasn't even in the thousands...there is a reason why Einstein referred to compound interest as the 8th wonder of the world! Now, obviously there isn't an investment that can sustain this kind of performance, it's just an example to drive a point, but even a $100/month investment at 12% annualized return can turn into more than $1,000,000 over 40 years. That means it's very realistic for a 25 year old entering the work force to retire as a millionaire at age 65, regardless of salary, based on historical stock market trend line performance. Time is our greatest asset. And taxes are our greatest liability...so let's keep this example moving along with that in mind.

 

If the example above were held in a tax free vehicle, such as a Roth IRA/401(k), Health Savings Account, or in certain situations a properly designed low fee cash value life insurance policy, the $1 million could potentially be yours to keep, income tax free. If the $1 million was protected by a tax-deferred vehicle such as a Traditional IRA/401(k) or a low fee variable annuity, the earnings could be tax deferred until withdrawn. This is also true to a large degree with certain tax managed equity mutual funds and ETF's that are able to avoid capital gain distributions.

 

But what if this example was exposed to income tax on the earnings every year at the current top Federal rate of 37%? Like before, guess what the ending value would be...So to be clear...

 

$1

End of year 1: $2 minus income tax (37% of $1 = $0.37)...$1.63

End of year 2: $1.63 * 2 = $3.26 minus income tax (37% of $1.63 = $0.6031)...$2.66

And so on, again for a total of 20 years...Make your guess now on the ending value.

 

  $1.00
1 $1.63
2 $2.66
3 $4.33
4 $7.06
5 $11.51
6 $18.76
7 $30.57
8 $49.83
9 $81.22
10 $132.40
11 $215.81
12 $351.76
13 $573.38
14 $934.60
15 $1,523.40
16 $2,483.14
17 $4,047.52
18 $6,597.46
19 $10,753.86
20 $17,528.80

 

Is your mind blown again? The bad news is that we can't really control what the financial markets do, but the good news is that we have a reasonable degree of control over protecting our investments from income taxes. It just requires we pay attention to the vehicles we put our money into, and the type of trades and strategies we execute in taxable accounts. Many traders and investors ignore the impact of taxes when considering a product or strategy, but it's simply unwise to do so if you're in a high tax bracket. It's not how much you make, but how much you keep, net of all fees and taxes.

That's especially true if you're also in a state with a high state income tax rate, such as CA or NY. Tax efficient vehicles, and tax efficient investment products and strategies are available to everyone today. As a CFP® professional, I can help my clients build long term financial plans and investment portfolios that align with both their unique willingness and need to take risk, as well as their unique tax situation. 

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter.

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • The problem of Option Math

    Option traders may be divided into two categories. First are those relying on instinct or casual observation. This group tends to speculate on directional movement, future volatility, value, and on potential profitability of trades. The second group is involved deeply with math of trading and depends on what is perceived as certainty or near certainty.

    By Michael C. Thomsett,

    • 0 comments
    • 195 views
  • Put/Call Parity: Two Definitions

    Traders hear the term put/call parity a lot, but what does it mean? There are two definitions and they are vastly different from one another. The first definition involves the net credit/debit for any combination trade, with trading costs are considered. The second definition takes assumed interest rates and present value into mind.

    By Michael C. Thomsett,

    • 0 comments
    • 213 views
  • Do Options Affect Stock Prices?

    It is widely acknowledged that the price of the underlying directly impacts the premium of the option. Therefore, options are termed derivatives. Their current value is directly derived from movement of the underlying price. Is the opposite also true? Does movement of the option value affect the underlying price?

    By Michael C. Thomsett,

    • 0 comments
    • 406 views
  • Portfolio Withdrawal Strategies

    This article will discuss three ways to take systematic withdrawals from your investment portfolio that would be expected to last 30 years, which is a typical time period a 65-year couple might need to plan for in retirement.

    By Jesse,

    • 0 comments
    • 304 views
  • Pricing Models and Volatility Problems

    Most traders are aware of the volatility-related problem with the best-known option pricing model, Black-Scholes. The assumption under this model is that volatility remains constant over the entire remaining life of the option.

    By Michael C. Thomsett,

    • 0 comments
    • 485 views
  • Option Arbitrage Risks

    Options traders dealing in arbitrage might not appreciate the forms of risk they face. The typical arbitrage position is found in synthetic long or short stock. In these positions, the combined options act exactly like the underlying. This creates the arbitrage.  

    By Michael C. Thomsett,

    • 0 comments
    • 684 views
  • Why Haven't You Started Investing Yet?

    You are probably aware that investment opportunities are great for building wealth. Whether you opt for stocks and shares, precious metals, forex trading, or something else besides, you could afford yourself financial freedom. But if you haven't dipped your toes into the world of investing yet, we have to ask ourselves why.

    By Kim,

    • 0 comments
    • 496 views
  • Historical Drawdowns for Global Equity Portfolios

    Globally diversified equity portfolios typically hold thousands of stocks across dozens of countries. This degree of diversification minimizes the risk of a single company, country, or sector. Because of this diversification, investors should be cautious about confusing temporary declines with permanent loss of capital like with single stocks.

    By Jesse,

    • 0 comments
    • 481 views
  • Types of Volatility

    Are most options traders aware of five different types of volatility? Probably not. Most only deal with two types, historical and implied. All five types (historical, implied, future, forecast and seasonal), deserve some explanation and study.

    By Michael C. Thomsett,

    • 0 comments
    • 605 views
  • The Performance Gap Between Large Growth and Small Value Stocks

    Academic research suggests there are differences in expected returns among stocks over the long-term.  Small companies with low fundamental valuations (Small Cap Value) have higher expected returns than big companies with high valuations (Large Cap Growth).

    By Jesse,

    • 0 comments
    • 1,050 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido