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By Jesse
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vehicle such as a Traditional IRA/401(k) or a low fee variable annuity, the earnings could be tax deferred until withdrawn.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.
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By Jesse
I’ll also continue to assume a 32% tax rate for short term gains and 15% for long term gains.
Writing puts on 1256 option contracts makes 60% of the gains Long Term Capital Gains, but those gains are fully taxable every year. This makes an 8% pre-tax return a 6.26% after-tax return. With an ETF BuyWrite strategy, most of the yearly profits will be unrealized in the form of share price appreciation. On an annual basis, I’m assuming the 8% return would be composed of:
ETF dividend yield: 1.5% Short call option realized gains: 0.5% Unrealized share price apperception: 6%
If we assume 80% of the dividend yield is qualified dividends, and the call option gains are 1256 contracts, the annual after-tax return falls from 8% to 7.61%. Updating the chart from the Part I article comparing all three strategies, we see the following differences in long term after-tax performance:
Summary
This illustration shows how taxes are a very important long-term consideration in a taxable brokerage account. While the results of all three strategies would be the same in a retirement account, they are very different in a taxable account. An ETF BuyWrite strategy has the advantage of deferring taxes on share price appreciation until shares are sold, which the investor has full control over. An investor can also tax loss harvest shares when unrealized losses exist by swapping from one ETF into another that is similar but not identical, booking a capital loss deduction.
After 30 days have passed, the investor is free to switch back to the preferred ETF. Investors who make charitable donations can gift highly appreciated shares instead of cash, then using the available cash to repurchase donated shares. The net result is an increased average price per share and lower future capital gains liabilities when shares need to be sold to meet financial obligations.
In retirement an investor could use dividends, gains from calls, and sales of shares to meet their spending needs. Even if the investor were to fully liquidate the portfolio at the end of year 30 the after-tax amount would still be $831,622, well in excess of either PutWrite strategy. Since ETF’s can be used as collateral for a margin loan, an investor could also take tax free margin loans instead of selling shares to continue deferring unrealized capital gains. Under current US tax law, unrealized capital gains would effectively be erased at death due to receiving a step up in cost basis.
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™ professional. 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.
Related articles:
Tax Efficient Trading Part I: The 1256 Contracts The Magic of Compounding, and the Tyranny of Taxes Traditional or Roth Retirement Account? Investment Ideas for Conservative Investors What’s Wrong With Your 401(k)? (If anything) First Time Trader? Here Are 3 Tax Tips You Should Know
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By Jesse
This is an advantage compared to stock and ETF options where realized earnings are reported as short term gains unless the contract is held for more than a year. In this article, I’ll provide a simplified example to illustrate how much of a difference this could make over the long term for someone paying 32% on short term gains and 15% on long term gains.
An interesting side note is that taxpayers in the 12% federal bracket, which currently extends to just over $80,000 of taxable income for someone married filing jointly, pay 0% on LTCG’s under current law. This simplified example excludes other taxes that could apply to your situation including state income taxes as well as the 3.8% Net Investment Income Tax (NIIT). I’m a financial planner, not a tax advisor, so readers should not consider this article to be specific tax advice. Always reach out to your own qualified tax advisor to discuss your personal situation.
Let’s assume a trader is debating writing puts or strangles monthly using either XSP or SPY. Since these contracts are the same notional size they can be used interchangeably with the biggest difference being how XSP is cash settled and SPY settles into shares. For the sake of simplicity, we’ll ignore other variables that can weigh into this product choice decision such as liquidity, where SPY generally holds the advantage.
Let’s then assume that the strategy is expected to make 8% gross annualized returns for the next 30 years with a $100,000 account. Net of taxes paid directly from the account, the 1256 contract (XSP) would return 6.26% and the traditional options contract (SPY) would return 5.44%. These differences in net return would compound to the following amounts in a $100,000 account over the next 30 years.
Summary
There are many important variables to consider when implementing a trading strategy. Commissions and slippage are routinely thought of by traders, but the long term impact of taxes are often overlooked. This example highlights how the tax advantage of 1256 contracts can be significant over a 30 year trading career. In my next article, I’ll extend the comparison to covered calls which can further improve tax efficiency. By making ETF’s the core asset, we gain more control over paying taxes by deferring capital gains until realized by selling shares or potentially even deferring them forever by taking a margin loan instead of selling shares.
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™ professional. 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.
Related articles
The Magic of Compounding, and the Tyranny of Taxes Traditional or Roth Retirement Account? Investment Ideas for Conservative Investors What’s Wrong With Your 401(k)? (If anything) First Time Trader? Here Are 3 Tax Tips You Should Know
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