Taxes and Investing: Don’t Make This Common Mistake

Paul Winkler: Welcome to “The Investor Coaching Show.” Paul Winkler here talking money and investing.

I’m going to go through a couple of things this hour that I think are going to be helpful regarding things to do and how risk can be controlled in an investment portfolio. I’m going to talk a little bit about that.

Selling on Emotion

I had something come up. We were in a meeting this week, and something was brought up about a webinar somebody attended or looked at or something like that.

But anyway, we were talking about taxes, and so often what we do is we make big decisions on investing that are tax-related. Some of the biggest mistakes, quite frankly, that I’ve ever seen people make were being made because of tax reasons. “We’re going to do this because this is going to save on taxes.”

There was a study — I talked about it last year some — and it was kind of a funny article. It was like the very biggest determinant of success as far as having enough income in retirement and retiring well and all of this stuff — and I can’t remember the title of the article exactly — but surprise, it was returns and making sure the investment portfolio was put together properly. That was by far the biggest deal, and I’ll get to that more in a second. That was by far the biggest deal.

But here’s what we do. Here’s a mistake that we tend to make as investors: We tend to get pulled in by taxes because we hate taxes, and it’s an emotional thing. And we know from psychology that we can be sold on emotional things, and we know that. Matter of fact, there’s an adage in sales.

“Sell on emotion, justify with logic.”

So if somebody is appealing to emotions, you kind of watch out and go, “Is there something going on here? Am I being sold to?” Keep that in mind. Think about that.

So watch yourself, especially when it comes to taxes because taxes are a very emotional thing, and that is one thing that people get pulled in on.

We were just talking about that this week in the office — how people are getting pulled in, and how we have to beat the man.

People controlling, “We’ve got to try to fight against the establishment,” is kind of this thought process that goes on with certain groups of people. You go, well, wait a minute, maybe the establishment sometimes is there to protect us. Think about the police riots and all this stuff. The police were being picked on, people were saying, “We have to defund the police.”

And you go, well, who’s protecting your rights to own property and hang on to things that are yours? You just go, what? Really?

So a lot of times it’s emotion that drives the bus when it comes to the decisions we make. And we’ve got to be super, super careful about that because it’s really easy to get pulled in.

Roth to IRA Conversions

As a matter of fact, there was one thing they were talking about regarding Roth conversions and Roth to IRA conversions. We have to convert.

We have to convert because tax rates are going up.

The point that was brought up is this: Would you rather pay tax on the seed, or would you rather pay tax on the crop? And that’s the whole thing that goes back years and years and years ago that people would talk about that.

I remember going through this one thing, this one program, and the whole program was designed to sell life insurance, of all things, as an investment. And I’ve talked about that before. It’s really not a good idea, in my humble opinion.

And yet if you look at the numbers, the problem is life insurance costs or mortality costs go up as you age, and just when you’re going to start taking income from your life insurance, your costs inside the product are skyrocketing because you’re more likely to die at that point in time. So it really sucks down your ability to take an income. If it lapses, you can have all kinds of bad tax consequences. That’s a whole different segment.

But here is what we were talking about regarding doing Roth conversions. This person was saying, “Pay tax on the seed; it’s much better because if you think about the seed, it’s a little tiny thing that you put in the ground and then it’s this big crop one day.”

Well, it’s just like saying, “Hey, let’s pay taxes on money that you earn right now. Don’t save taxes on your contributions.”

Think of a traditional IRA where if I take, let’s say $1,000, and I am in a 20% tax bracket — just to keep the numbers nice and round and easy — if I put my $1,000 in and I get a 20% tax deduction, I don’t have to pay $200 in taxes today. If I take the money and pay taxes right now, it’ll whittle down to $800 because I’ll have my $1,000. I pay the $200 taxes, 20% of the $1,000, and then what’s left is $800. Well, that’s much better, isn’t it?

Then in the future when the money grows to a large sum of money, when I could be paying maybe tens of thousands of dollars in taxes, wouldn’t it be much better to pay $200 in taxes right now? And it sounds good — pay tax on the seed; don’t pay tax on the crop later on. But the math is just really bad, especially in the example that was given.

Now, there are some times when it does make sense. Let’s say you’re in a super, super low tax bracket, maybe you’re in your first job — or like my kids, I had them putting money in Roth IRAs, no question.

There was nothing that made any more sense because their tax bracket was zero. They have only one way to go in the future, which is up. Or if it’s like 10% or something super, super low, it makes sense that you could put the money in and pay a tiny amount of taxes on a 10% rate.

The Math Behind Tax Decisions

In this particular webinar, the person was telling me that even if you’re in a really high tax bracket now, like 37%, to go ahead, pay taxes right now, put the money in the Roth IRA and then later on it will be much, much better that you paid that little tax we were talking about. And I said, “That is just ridiculous. That’s bad math — if you don’t think about the differential, and this is how you make that decision.”

The example was this: Let’s say I had, I’m going to use $10,000, and let’s say that my tax bracket was 37%. And I say, “Well, I’m going to go and take that $3,700 and pay those taxes right now and then I’ll invest the $6,300 in the Roth because it’s way better to pay $3,700 in taxes now than have that $10,000 grow into the future.” And let’s say that 40 years down the road, now that $10,000 — let’s say, if I use a 10% rate of return — is $452,000.

And then let’s say that I’m in a 20% tax bracket at that point in time — then I’ve got $90,000 in taxes I’ve got to pay. Well, isn’t it way better to pay $3,700 in taxes right now versus paying $90,518, to be exact, in the future? And you think, Oh yeah, man, sure, that makes a whole lot of sense.

What it ignores is what’s really going on math-wise.

Because if I take that $10,000, and I’ve got $3,700 in taxes that I pay right now, I’m forgetting that that $3,700 is gone forever. And if that $3,700 is gone forever, it’s not there for me to earn income on anymore, right? Because it’s gone, it’s been sent to the government.

Now look at that $3,700 over that same period of time — I’m using 40 years and I’m using 10%, just to use an example — and you get this, that $3,700 is about $167,000 in the future. So you look at that and go, “Well, wait a minute. If I had left it there, I would’ve enough money to pay that tax that I talked about and then had a lot left over.”

So it’s challenging math. Let’s just put it that way, to actually say that.

Now, here’s what I look at: What is the bracket that I’m avoiding right now? What tax rate am I avoiding now versus what is it likely to be in the future?

And there are a lot of things that actually make it even a little bit more complex, in that we look at our tax systems right now and we go, “We’ve got this 10% bracket and 12% bracket, 22% and 24%, and it just goes on up to 37%.”

Push to Pay Taxes Now

You have this big push to pay taxes right now with a lot of different entities out there saying, “Do Roth, do Roth, take and pay all the taxes and just convert your IRAs over.” You even hear this from the government, and you see some rules that the government has instituted in order to get people to pay taxes right now. And you think about, well, why?

Because we’ve got a federal budget that is a mess and debt that’s out of control.

Let’s say we get a lot of people to pay taxes right now, convert everything over, pay taxes, pay taxes, and all of a sudden, all this money comes in. And then later in the future — you just imagine it down the road, 20 years, 30 years down the road — our federal debt is absolutely skyrocketed, it’s horrible and things are bad, and we’re still having to pay for stuff and we still need tax revenue.

You imagine the government sitting there and going, “Oh, we got all this money in Roth and it’s tax free. What are we going to do for tax revenue? Hey folks, have any ideas?”

They’re talking amongst themselves in Washington. “Yeah, yeah. Why don’t we do what they’re doing in Europe and have a value added tax or a consumption tax like we do with gas taxes?”

A big part of what you pay for gas is just taxes, but you don’t see it because you’re pumping the fuel into your tank. As a matter of fact, it’s kind of an interesting thing. Even now, if we go electric, how are you going to get money for the roads for things?

That’s a whole different topic. ADD, I’m going ADD on us.

But you think about it and go, oh my goodness, we pay for road repairs through gas taxes. Actually, this is a really good example. This is a really good example. I just kind of swerved into it.

But you think about this. We’ve been paying taxes on our gas for road repairs forever, and now we’re starting to look around and going, well, wait a minute. If more people are starting to drive cars that are run by battery — and maybe that starts to get a little bit better in the future, or maybe we go to hydrogen, or we go to natural gas or whatever — and all of a sudden now we have nobody buying gasoline, which is taxed, and those taxes were being used for road repairs — what is the government going to do to make sure that the road repairs take place?

Well, they’re going to find something else to tax. They’re going to figure out some other way of doing this, which is just what I’m talking about regarding this. If all of a sudden everybody’s money is sitting in Roth IRAs and you can’t tax that money because it’s already been taxed, what are they going to do?

They’re going to look for something else that they can tax, and consumption taxes are a pretty obvious example.

Thinking Tax Decisions Through

So my point is, we have to think like the government does. There’s this concept we call cat and tax diversification. But this is the thing: The investment firms use this type of concept of paying a tax and moving it over. And you hear this push because it’s emotional.

They’re not thinking like the government thinks or they’re not thinking through things. They’re just thinking of immediacy. “How do we get people, how do we bring them in as clients?” We appeal to taxes.

Why? Because that’s what people want to hear about. They’re sold on emotion. We will justify with logic in some way or another, or if what I’m talking about ends up happening later on, we say, “Oh gosh, I just didn’t think that the government would do that.”

That’s exactly what I saw in my career, and I’ve been doing this for a long time. I saw this with tax shelters in the 1980s. There were a lot of ways to reduce your taxable income that sounded really good, and technically they were legal on paper. The only problem was the laws changed.

And all of a sudden people are caught going, “Oh, I didn’t know they’d do that.” And you go, well, if you look at it, it was something that was just likely to happen based on the numbers.

You knew somebody would come in and say, “This doesn’t make any sense. We need more tax revenue, and this is an obvious thing to shut down these tax loopholes, and these tax shelters are an obvious thing to shut down.”

So I think it’s just really, really critical that we think through these types of things. Be very, very careful about the tax tail wagging the dog, because you may be the one down the road going, “Oh man, I just wish that I’d thought through this a little bit more.”

It is a big marketing thing being used right now, and my premise is, watch out, because most of the information we get about investing and about financial planning is really just marketing in disguise.

Be aware of it, think about it and don’t fall for it, because it can get really expensive.

Return Makes a Difference

I just want to hit something really quick because I’ll spend a little bit more time on things that we can do to help control risk in our portfolios, a couple of strategies that are often used and often talked about but rarely implemented.

Now, one of the things that we find, especially with the younger investor, is people blindly trusting employers and employer plans and just blindly trusting that when you have a 401k and they’re investing the money for you, you can just give it to them and they’ll handle it in the proper way, based on your retirement age.

And you hear me talk about these target date funds from time to time. I want to walk through something because it’s going to come up when I talk a little bit about the things that you can do to help manage risk when you manage a portfolio.

There’s also a return aspect to this that is incredibly important.

Now, let’s just talk about return and why it’s such a big deal. Let’s say that I had $10,000, and I’m just going to use this as an example, and I had 40 years, and I go into the future.

So I’m going to use that example. Same numbers. 10% return.

Let’s use the historic return of the S&P 500. I’m just going to use that. Going back in almost every 30-year period, it’s one plus one minus one from that. And it doesn’t matter what 30-year period you’re looking at in history, from the 1920s until today, it’s around right there.

If you look at $10,000 invested over 40 years at that rate of return, it grows to about $450,000. Okay?

Now, let’s say that you take that and the rate of return is 12. It’s $930,000. So you look and go, wow, that’s a pretty big difference between the two of them, right?

You go 10% return, it’s going to be that $450,000. And it’s double, as we talked about, if you go to 12%. And you go, whoa, that’s a huge difference.

Asset Mixes

Now, technically I’ll always like to inflation-adjust returns, but I’m just making the point about returns, and I want to make a point about asset mixes and what a big deal that is.

There’s a study that was put together by Brinson, Hood and Beebower. They were actually looking at pension plans, and they said, “What drove the returns? What was the biggest determinant in returns and the variation in returns between pension plans?” And it was asset mix and asset allocation.

How much do I have in large companies? How much do I have in small companies? How much do I have in value companies?

How much do I have in growth companies? How much do I have in US, international and so on and so forth?

Now, when you look at that decision that you’re making with your 401k, always the decision that I’m looking at is how much first in stocks and bonds, stocks versus bonds. Typically when I’m younger, I’m going to be more stocks than I am bonds because I need to have protection against inflation. Historically, bonds do not protect against inflation.

Then I’m looking at how much to put in small companies versus large companies.

Large companies would have a lower expected return. Smaller companies have a historically significantly higher return.

Value versus growth. If you look at value versus growth in general, it’s about four to five percentage points per year. Now, I just gave you an example of two percentage points per year.

It’s four to five percentage points per year in value versus growth. And you go, “Well, which one’s higher?” Well, value.

Well, what are they focusing on in target day funds? Large, the lower of the two between large and small, and growth, the lower returning of the two between value and growth.

Companies That Focus on Large Funds and Growth

Okay, so what on earth is going on here? Well, you look at it, and I’m just going to use four fun companies that advertise a lot, just to show that this is not something unusual. This is not just cherry-picking — there are certain companies that do this.

If you look at Vanguard, for example, their target 2050 fund as of January 2024 is 53% US stocks and 35% international, so way more US than international. If you look at the holdings, you only have 1.24% of the portfolios in very small companies, micro-cap.

Only 4%, 4.78% is in small. So you look at it, and it’s like 5% to 6% of the portfolio is in small.

Where do I expect more return? Large. Well, 95% of the money is in larger companies. Then you look at value versus growth.

And if you look at the weighting of the portfolio, of the portion that is in the large part of the portfolio, you’re looking at literally what? I’m doing it by eye, about 60, 70, about 80, 90%. Of that, the vast majority of it, let’s see, what is it math-wise?

I’m just kind of going through it. It’s two-thirds of it. Two-thirds, no more than two-thirds. Yeah, good grief.

Yeah, about four-fifths of the portfolio is in large and blend. So you have, weighting-wise, the vast majority of the money sitting in blend and growth, which is the more growth-oriented portion of the portfolio.

And you go, “Well, what on earth? They’re really, really overweight and they’re where I would expect more return. That doesn’t make a whole lot of sense. And why are they doing that?”

More about that in a second. But so you’re looking at about three-quarters of the portfolio and re-looking at the numbers there.

Now, we look at American Funds, another big fund company, and say, “Well, are they any different?” Well, again, US stocks are highly overweighted versus international. 60% of the portfolio versus 25% of the portfolio.

Man, it’s even more pronounced. More than 75%, 80% of the portfolio is in large, the growth and the blend.

And you look at that and go, “Where do I expect more return value?” Well, there’s not much there.

If I look at the small value, where you have the highest expected return, according to Morningstar, it’s only 1% of the portfolio. Only 1% of the portfolio is in that area. 2% is in blend, in small blend.

Then you look at, okay, well, what about Fidelity? Surely, Fidelity is a huge company. Are they doing things any differently over there?

This is their Target 2050 fund. Now, they are a little different as far as US versus international: 47% US, 40% international, a little bit more in that area. But if we look at the weighting of the portfolio it’s 24% blend large, 34% growth and 17%.

So we’re, again, looking at about three-quarters of the portfolio sitting in the bigger growth blend-oriented asset category.

That asset mix has only 2% in small value and 3% in small blend. So again, we’re seeing the same thing over and over.

Voya, another company, we’re seeing lots of advertising by them these days, what are they doing? What does their asset mix look like? Let’s see.

Asset mix weighting was 27% in 2017. So again, in about a year, we’re looking at about three-quarters of the portfolio in growth and blend, 62% US, 25% in international — a lot more US focus on the portfolio — and 3% in small value. That’s it.

Holding More Money in Large Companies

So what is going on here? Well, it is safe. Have you ever noticed that in life, it’s just safe to look like everybody else? Number one, it’s safe from a marketing standpoint to look more like everybody else and hold more money in large, big, well-known US companies.

If you look at the top holdings in these portfolios, you are going to see that the top holdings are those huge companies, the Apples, the Microsofts, the ones that you see in the media all the time and being talked about all over the place, but those are the companies whose price is super, super high compared to earnings and book value compared to the rest of the S&P500. I’ve talked about that before.

So you look at the cost of capital or the expected future returns of those types of things.

Those companies historically have lower returns because they don’t have to pay that much to use your money.

They’re really, really big companies. Really, really big companies don’t need your money as much.

So if you’re looking at their bonds, you would see that the interest rate that they pay on bonds is very low because they borrow out of convenience. Well, if you look at the stocks, why would the stock market be any less intelligent on what to charge to use money? They’re not.

They would love to charge those huge companies that are well-established and well-liked — well, sometimes well-liked, sometimes vehemently hated in some circles. But you look at that and you go, “Well, I would love to charge you guys more money, but I can’t, because you won’t pay it.”

Another way of thinking about it is, if I am going to sell a stock in a company like that, if it’s well thought of or has a good future prospect for earnings, I could sell it for a high price compared to the earnings that I will get. Historically, what does that equal? Lower future expected returns.

Remember I said earlier, value stocks versus growth can be four to five percentage points, the data shows. So if you look at the data on value versus growth, you see value historically has a four to five percentage points difference, which is a big, big deal. It’s a huge deal historically.

The Time Value of Money

So what we’re doing is we’re looking at those companies, those big well-known companies being more growth-oriented companies. That doesn’t mean that their stock price will grow. That means that they have grown and that they are really strong from a profitability standpoint. Therefore, they sell for a very, very high price for every dollar of earnings.

You’ve heard me say this before if you’ve listened to this show, probably: 95 to 96% of a 20-year period’s value has a higher return than growth does. And yet what are we seeing with these target date funds? The opposite approach.

Why? Marketing. Watch out for it. It is everywhere.

Younger people especially — who tend to be the people that are not really tuned in, in a lot of instances — need to pay attention to this because they think it’s going to be a long time before they need this money.

I’ve often said that by far, what I’ve found is that I find that people tend — and the studies back me up on this — people tend to really start to focus on their investments and their finances in their 50s. It would be great if we get people younger to actually focus on it, but they just don’t tend to do it because it’s such a far-off thing.

But remember, if we look at the time value of money, long periods of time show us the biggest differences.

In short periods of time, a couple of percentage points difference doesn’t make that big of a difference. If you’ve got 30, 40 years, 50 years, good grief, it could be a huge difference.

That’s why I just plead that younger people listen to this kind of stuff. And if you’re an older person listening to this and going, “My kid needs to hear this,” well, that’s why you sign up for the podcast and send this segment to your kid. That’s what we do for people we care about, right?

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.