The Taxable Investor's Manifesto. Stuart E. Lucas

because tax efficiency is valuable, it does not stand to reason that all tax-efficient investments are good. Life insurance is widely sold as a way to eliminate taxes on profits and to avoid estate taxes, but it will only be a good investment if the underlying structure, terms, and assets are sound. Similarly, Qualified Opportunity Zone funds, approved in the 2017 Tax Act, are tax efficient. But they will only serve taxable investors well if the underlying investments generate decent profits. One of the potential issues with vehicles that shield you from taxes is that if the investment turns out to be a loser, you will suffer 100% of the loss. Ironically, not all losses are bad if they are structured properly and the government is your partner in the loss. Later in the book, we will explore an investment technique called tax-loss harvesting, where one explicit purpose of the strategy is to realize losses in part of your investment portfolio to offset the tax otherwise payable on other realized investment profits.

FIGURE 1.1 A FRAMEWORK FOR TAXABLE INVESTING.

      Parenthetically, as we've already explored, some investments may appear to generate decent returns, but after being subjected to inefficient structures, high fees, and tax rates of 50% or more, in fact they aren't so great. As a general rule, the shorter the hold period of an investment and the more of its total return that comes in the form of taxable income, the higher the risk-adjusted, pretax returns need to be in order to justify their inclusion in taxable portfolios. In the chapters ahead, we will explore further how to invest in that upper-right-hand quadrant with consistency and success.

      Most predictably, the best investments for taxable investors are ones that generate decent to strong capital gains for long periods of time. Nevertheless, even with success there are consequences. As unrealized gains grow, a rigidity creeps into taxable portfolios: the more successful an investment becomes, the more expensive it is to sell and the harder it is to replace. With greater rigidity, each decision about whether or not to sell becomes more important and more deserving of studied, professional analysis.

      Estate planning can also have a big influence on where an investment falls in the two-by-two matrix shown in Figure 1.1. Anyone can establish tax-deferred or tax-exempt retirement plans. Assets that would otherwise be in the bottom half of the matrix move to the top half if they are in one of these vehicles. Tax-inefficient assets within retirement plans add diversification in the traditional sense. They also give you the means to manage future changes in tax rates. As wealth grows there is also the opportunity to share it with others: children, grandchildren, philanthropies. Good estate planning can be incredibly valuable, both for tax planning and for perpetuating family business.

In some ways, all these moving parts add complexity to taxable investing. But an investment strategy, designed and executed with forethought and care, will minimize the adverse impact, and maximize the upside with high probability of success. Taxable investors and their advisors have tools at their disposal, some of them low cost and quite straightforward, to increase net-of-tax-and-fee returns. Understanding how to create better odds of success, where to look for higher magnitude, how to measure risk symmetries and how to retain a higher proportion of profits creates additional benefit. That understanding also will encourage advisors and their taxable clients to ignore vast areas of the investment ecosystem. Most hedge funds, most credit-driven funds, most real estate funds, and most actively managed equity funds are structurally unattractive for taxable investors, even if they make sense for tax-exempt ones. A reduced universe of investment options makes investing easier for us by tightening our focus exclusively onto those opportunities that have the best odds of adding value net of taxes and fees.

KEY CHAPTER TAKEAWAYS

       Taxable investors should evaluate the symmetry of risk, magnitude of profit, probability of winning, and profit retention rates from their unique perspective.

       Given all their differences, managing taxable and tax-exempt portfolios using the same investment theories, the same analysis, the same structures, the same metrics of performance, is not acceptable. We taxable investors need to think and act differently than tax-exempt investors, and our advisors should too.

       The character of profit determines the rate at which it is taxed and when it is taxed. It's important to understand the differences.

       For taxable investors, the more successful an investment becomes, the more expensive it is to sell and the harder it is to replace. Over time, each buy and sell decision becomes more and more important.

       Costs also affect taxable profits. Many investment funds are structurally more attractive to tax-exempt investors than to taxable ones. Avoid them and focus on a smaller and more sensible set of options.

      Notes

      1 1 For a detailed analysis of the after-fee and after-tax returns of index funds, mutual funds, hedge funds, and private equity funds review, see Stuart Lucas and Alejandro Sanz, “The 50% Rule: Keep More Profit in Your Wallet,” Journal of Wealth Management 20 (no.2, Fall 2017).

      2 2 This isn't entirely true. In their prospectuses – but rarely transferred into their marketing material – mutual funds are required to provide estimates of after-tax performance. This level of reporting is not required, and rarely calculated by Exchange Traded Funds, alternative investments like hedge funds and private equity funds, or separately managed accounts. But even for mutual funds this information is not widely circulated or analyzed.

      3 3 Individuals may only deduct a maximum of $3,000 of final net short-term or long-term investment losses against other types of income.

CHAPTER TWO Diversify at the Right Time and in the Right Way

      Most people think of “diversification” as a financial investment strategy – what percent of stocks, bonds, hedge funds, private equity, venture capital, and real assets should comprise an investment portfolio? But before any of us has the opportunity to think about this aspect of diversification, first we have to accumulate wealth. That almost always requires long-term, concentrated investments of effort and capital. This chapter explains how and when to turn concentrated wealth accumulation into cash for potential reinvestment into that diversified portfolio of financial assets.

Most talented, ambitious people start their professional lives with minimal assets, often some debt, minimal earnings, and lots of earning potential. You can think of that earning potential as a large but intangible asset. Over time that intangible asset changes form. Earning potential converts into actual earnings that can be used to eliminate debts and pay living costs. Whatever earnings are left over convert into savings – a tangible asset.

      In addition to receiving salaries, some people are compensated with concentrated ownership in one company through stock, restricted stock, and stock options. Equity in this form can offer great benefits for entrepreneurs, leaders, and managers in growing companies, but it isn't very liquid, and its value will follow the company's fortunes. In other words, it's risky.

      In professions like dentistry, teaching, and many others, where reasonably predictable careers provide reasonably predictable cash flow but little opportunity to “equitize” professional skill, saving cash earnings is the only way to build financial assets and to diversify personal balance sheets. The earlier the saving process begins, the longer the savings can compound and the larger they can grow. Professional athletes, actors, authors, and others whose earnings