Stealth Taxes Consume Stock Gains & Retirement Plans, Part 1

by Daniel R. Amerman, CFA

Below is the 2nd half of this article, and it begins where the 1st half which is carried on other websites left off.  If you would prefer to read (or link) the article in single page form, the private one page version for subscribers can be found here:

Subscriber One Page Version

Testing The Results

Most investors have likely not seen their stock performance analyzed in the precise manner shown above. Some aspects are indeed a bit unusual, but the reason for this approach is to help foster a clearer understanding about what has been happening in practice for many millions of investors.

There is also a simpler – and irrefutable – method of confirming the results. If we start with $100,000, and we buy the S&P 500 at 970, and we sell it at 1,426, then our ending portfolio is $146,965 (leaving out rounding).

Thirty percent taxes on $46,965 in profits equals $14,089, which leaves us with an after-tax portfolio of $132,875.

Adjust for changes in price levels per the CPI-U, and at the end of 2012 the dollar would only buy 69.91 cents when compared to what it would buy at the end of 1997.

Multiply our after-tax portfolio of $132,875 times 69.91%, and clearly and unmistakably, the after-tax and after-inflation value of our portfolio is $92,888, which is a loss of $7,112 in purchasing power, precisely as calculated above.

By just doing this basic math, the appearance of a sweet 47% profit turns into a 7% loss in what we can buy after we've paid taxes.  And this same math very much applies in the real world to millions of investors,

The root of the problem is that people don't understand the underlying relationships.  Millions of people have a very solid basis for believing they have made a nice profit over the years. Yet in the real world, those millions of people are simultaneously finding out the purchasing power of their successful investment portfolios turned out to be much less than they hoped it would be.

Understanding the relationship between inflation, real returns and taxes is essential if we are to have a chance at building real wealth.  Hopefully this walk-through has provided some insights into what may have been going on "under the hood" with your own investments since the late 1990s.

An "Optimistic" Analysis?

The bottom line of this analysis may look a little bleak, though one might hold out hope that in their individual experience they actually fared much better than that.

Unfortunately, however, whereas the analysis assumes a performance that was exactly even with the overall market – long-term studies of actual investor results indicate that most people have done even worse than what has been shown.

Basic human psychology is that most of us tend to buy investments when we see prices rising, and sell investments when we see prices falling.  Even a slight tendency over the years to "buy a little high" and "sell a little low" can be problematic, given that the way to beat market averages is the opposite strategy of buying low and selling high.  This human nature-based tendency skews down average investor performance, meaning that most people who invested in S&P 500 stocks during the 15 years shown didn't do quite as well as the average results shown.

Another issue has to do with inflation perceptions and inflation statistics. Most people when looking at officially reported inflation statistics for the 15 years analyzed – which per the Consumer Price Index show an average annual rate of inflation of 2.42% – would likely say that inflationary fears were greatly overblown, and that inflation turned out to be a non-issue for investors.

Arguably, the reason for this common belief is that relatively few investors see the world in the way that is mathematically explored herein, which is an intertwined world of inflation, real growth and real tax rates. 

Inflation could be called the "father of all lies" when it comes to investments and economic statistics.  As covered in my previously linked article "How Financial Reality Is Hidden By Commonly Used Theory And Jargon", the two most common ways in which inflation is presented are each inherently deceptive, covering over the truth rather than exposing it. 

The negative effects of being unaware of inflation's true impact is greatly exacerbated by the subtle power of the mathematical relationships, which seem to violate common sense.  A 2.42% rate of inflation seems like it should be very minor, with little impact on a plainly obvious near 50% surge in stock values.  The adjustment for inflation seems like it ought to be a technical footnote, rather than dominating the bottom line.

Reality is, however, that even a relatively "minor" rate of inflation is sufficient over time to turn 47% profits into 7% losses – simply through viewing investment results in after-inflation and after-tax terms.

A still bigger issue comes when we understand that the methodology which the government uses for calculating inflation rates has changed quite a bit in recent decades. Current calculations lead to lower reported inflation rates than the old methods.

And if the prices that you've personally been paying for food, gasoline, health insurance, college tuition for children, utilities and so forth seem to have been rising at an "old-fashioned" rate of inflation rather than the 2.42% derived in using more recent calculation methodologies, then there is a huge impact on these results. There are no real profits at all, and the amount of starting net worth lost to the government in purchasing power terms grows much higher.

Another crucial issue is that for purposes of simplicity and conservatism, we have ignored financial fees. Investors who have to pay fees in practice and are not able to ignore fees for theoretical modeling purposes, would experience worse financial results in the real world than those shown herein.

Investor Implications

For most investors, there are two major implications for what has been covered in this article.

The first implication is that most investors face a daunting challenge in the years ahead. The results presented herein reflect real-world results for an entire nation over a 15 year period. Even if we assume that economic growth and corporate profit growth are each positive in the years ahead (so we're not talking a bleak economic future), but they're not as strong as they were in the late 20th century, and if we see inflation at even historic norms (so no hyperinflation) then on a national basis, investors will likely still have a serious problem.

Stock indexes would continue to rise, with widespread financial headlines trumpeting the good news at each stage. Yet, for millions of investors, as they consider when they can afford to retire and what their lifestyle in retirement would be, the bottom line of what they can buy with after-tax dollars is all too likely to continue to be a major disappointment.

If tax rates have another round or two of increases – as a nation struggles to deal with the costs of exponentially growing retirement promises, high debt levels and persistent high real unemployment – then as a mathematical necessity, the real bottom line of after-tax purchasing power will grow much worse, even as the "mystery" for millions of investors will continue to deepen.

The second implication is that a daunting challenge may in practice turn out to be an impossible challenge for millions of investors if they can't see with clarity what the real challenges even are.

That said, while fighting the combination of potentially lower growth rates, persistent inflation, and potentially rising tax rates may be difficult – there are solutions. However, the strategies used to fight these stealth taxes are quite different than conventional strategies, which are based on completely ignoring these taxes. And the only way to effectively protect oneself is to stop ignoring them, and thoroughly understand what is happening.

In other words, education is the first step. Hopefully this research-based tutorial has been helpful in that regard.

In Part Two we will continue our exploration, as we build in 15 years of historical dividends and the reinvestment of dividends, while taking our understanding to the next level.