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Investing for a Lifetime: Managing Wealth for the "New Normal" by Richard C. Marston

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CHAPTER 6 Savings and Taxes

Investors have to save in order to accumulate wealth. And they have to invest wisely to earn high enough returns on those savings. But how much wealth they accumulate depends on three other factors. These three factors, all of which inhibit the accumulation of wealth, are inflation, taxes, and fees.

In Chapter 2, I emphasized how important it is to take into account inflation. Real returns, not nominal returns, are important to wealth accumulation. Investment fees are discussed in Chapter 15 where we explain the importance of benchmarking portfolios. In this chapter we discuss taxes. Taxes drag down returns, so they limit the amount of wealth that is accumulated for retirement. But taxes vary by asset class. Even within an asset class, investments differ in their “tax efficiency.” U.S. tax law, moreover, provides methods for deferring taxes for retirement. So it’s important to study how taxes affect the accumulation of wealth.

HOW TAXES REDUCE INVESTMENT RETURNS

In Chapter 2, we study returns on stocks and bonds in the long run. But those returns ignore taxes. Only a tax-exempt investor would actually earn those returns. We need to consider the effects of taxes on those returns.

Investment returns are taxed in various ways. Interest earnings on bonds are taxed at the same rates as ordinary wage income, while long-term capital gains on any asset are taxed at capital gains rates. Capital gains for holding periods of a year or less are also taxed ...

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