As a nation we face many challenges:
• Our federal government spends a lot more than it brings in. The ratio of expenditures-to-receipts is running at an unsustainable level -- careening towards eventual disaster. The federal government deficit is now 7.2 percent of GDP.
• Total outstanding government debt of all types is now 165 percent of GDP. As recently as 1981, this number was a far more modest and responsible 52 percent. These figures include gross federal debt, government-sponsored entity (e.g., Fannie Mae) debt, state debt, and local debt.
• The U.S. net international investment position has reached -27 percent of GDP. In other words, we would have to take 27 percent of our current GDP to pay foreigners back for all the capital we’ve received from them.
• Just two entitlement programs (Social Security and Medicare) currently consume 8.6 percent of GDP. Based on the current structure of these two programs, this figure will increase by +50 percent, rising to 12.8 percent of GDP by 2085 -- a truly unsustainable level.
• The U.S. economy is expected to experience unusually low economic growth for the decade ahead.
• The American public has clearly communicated their unwillingness to cut back on entitlement programs.
Collectively, these factors will have many effects. However, one effect rises far above all others -- taxes are going up and by a lot. We are likely to see, not just a single tax increase, but unfortunately, a series of sequential tax increases. Just as in Spain, Italy, Portugal and Greece, those nations that insist on living beyond their means must eventually pay the piper and radically increase their tax rates.
So, what to do? Let’s try a thought experiment and work through a hypothetical investment scenario with and without active tax management. Here are the assumptions (overly simplified, but they allow for straightforward math):
The Hypothetical Investment:
• 12-year investment period
• Investment earns a constant 10 percent per year, with 8 percent coming from capital gains and 2 percent from interest income
• All capital gains are short-term and realized in the year that they occur
• All interest income is fully taxable
The Hypothetical Investor:
• 43 percent tax rate on interest income
• 43 percent tax rate on short-term capital gains
• 20 percent tax rate on long-term capital gains
Under these assumptions, the pre-tax return is 10.00 percent per annum, but the after-tax return falls to 5.70 percent
Let’s assume we could actively tax manage this account such that the following held true:
• The realization of capital gains are delayed by 3 years (for tax purposes)
• 65 percent of all capital gains are converted to long-term status
• Interest income is converted to municipal tax exempt interest
• But, as a consequence of the use of municipal bonds, the interest rate falls by one-third
The results of such an active tax management program increase the realized after-tax return by over 34 percent, from 5.70 percent to 7.65 percent. The serious question then becomes, are such active tax management benefits (a 34 percent improvement) both reasonable and achievable? I would argue the answer is, absolutely yes. But success will require the active combination of seven synergistic tax management techniques. Let me explain.
Tax minimization relies on three main strategies -- Delay, convert and replace: