Are You An Overtaxed Investor?


Reading is an easy and important way to increase your personal financial knowledge. The Overtaxed Investor is a great read for those looking to reduce investment related taxes.

As part of your Continuing Financial Education (CFE), you should get in the habit of picking up 1-2 books a year on financial topics.

I know. They’re boring. It’s dull.

But you made it through 1L year and Supreme Court cases from the 1800s. You can handle some personal finance books.

If you don’t learn about money on your behalf, who will? You at least need to know the basic vocabulary even if you’re working with a financial advisor.

Today’s book is The Overtaxed Investor by Phil Demuth.

Phil Demuth is the managing director at Conservative Wealth Management (we have no financial relationship) and the author of a series of personal finance books, many of which are classics in the community.

His latest book focuses on reducing investment related taxes (yes, it’s that narrow and doesn’t cover deductions). Why would you care? Because Demuth lays out in the first chapter all the taxes you’re paying and how the tax drag is costing you major money over the course of an investing career.

Not surprisingly, he first recommends that you set up your tax-deferred accounts so that you can save money today.

The central truism of tax planning, the one we want to spotlight in CinemaScope and Technicolor by Deluxe, is that a tax deferred is a tax not paid. Once a tax is paid, your money is gone forever. Why pay a tax today when you can pay it ten or twenty years from now and earn interest on the “float” in the meantime? This is why Daddy Warbucks sings, “Tomorrow, tomorrow, I love you tomorrow, you’re always a day away.

But Roth accounts still have a place as well, despite the concern that they may be taxed in the future.

Some people fear that Congress will add Roth distributions to adjusted gross income (as they did with municipal bond income). This could trigger higher taxes on Social Security payments and raise Medicare premiums, making Roths less desirable. So would scrapping the income tax for a flat tax or a value-added tax or a national sales tax, because it means we wasted the forgone tax deductions we could have taken to fund traditional IRAs and 401(k)s.

Since theoretically a Roth account will never be taxed again, Demuth argues that you want your highest long-term expected returns in the Roth account.

The bigger this account grows, the happier you will be. Place the assets here that have the highest long-term expected return. Emerging market equities might fit this category. A small cap value stock fund would also be a good choice. More simply, stocks. I also put moonshots here. Your crazy brother-in-law works for a startup. He gets you a hundred shares. There is a 99.9% chance they are worth zero and a 0.1% chance they are worth a million dollars. Put them in a Roth if you can.

But what about your taxable account? Demuth makes a controversial (but smart) recommendation in an entire chapter dedicated to “zero-dividend investing”.

The problem with dividends showing up on your doorstep during your peak earning years is that you really don’t want them. Now don’t get me wrong, it’s great that companies are growing and producing cash, but if you’re in the 39.6% tax bracket (or, any tax bracket) with no need for the dividend income, the last thing you want is to pay tax on annual dividends distributed to your taxable account.

Warren Buffett explains this well in his 2012 Letter to Shareholders (analysis on dividends starts on page 19). Buffett says that Berkshire Hathaway doesn’t distribute annual dividends because it’s more efficient to reinvest the company’s cash in the company itself, thus increasing book value, rather than distributing that cash to investors. Buffett makes a convincing argument that you’ll be better off selling 4% of your Berkshire Hathway stock thereby creating a “synthetic dividend” than you will if Berkshire spits out the 4% to you each year.

But going Back to Demuth’s “zero-dividend investing”, he writes that ideally the overtaxed investor would prefer a broad based index fund with zero dividends. I know that I certainly would. Unfortunately, many companies in the S&P 500 distribute dividends, so the only way around them is to exclude them from your portfolio.

And no such index exists.

With computerized trading, someone might offer a portfolio of all the zero-dividend stocks in the S&P 500 (or whatever index, the bigger the better) with automated tax-loss harvesting. Unfortunately, the robo-advisors currently seem more intent on reverse-engineering Vanguard circa 1988.

Demuth also doesn’t seem to think that one will be created, in part because mutual funds themselves are on the way out.

In the future, mutual funds will be dinosaurs. Most of them already are—they just don’t know it yet. The mutual fund will be replaced by the personal fund. You will hold one fund: Fund U. It will not be exactly like anyone else’s. It will be uniquely computer-optimized to your personal ecosystem, taking into account your age, life expectancy, life-stage, employment, residence, geography, tax profile, appetite for risk, concentrated holdings, employee stock options, total indebtedness, and your personal goals. It will fit like a glove. While the mutual fund was supposed to neutralize all but market risk, the personal fund will diversify personal risk. Mutual funds are brontosauruses that have been made extinct by the giant technology meteor that just hit. It is time for them to adapt or die.

Given that there’s no practical way to implement a zero-dividend portfolio of the total market, putting one together yourself is probably not worth the headache. Not to mention that you have to weigh the uncompensated risk against the tax benefit. I don’t think it’s worth it, but I still appreciate the argument. It’s important to think about eliminating tax drag in your portfolio wherever you can.

In addition to the above, Demuth’s book contains excellent chapters on other ways investors reduce taxes (oil and gas, real estate, etc.), how to handle moving through the tax brackets at various stages in your life and what to do about estate taxes.

Overall, I think the book is well-written, even funny at times, and definitely worth your time. Pick up a copy and read it!

Editor’s Note: This post contains affiliate links. This means I get paid a tiny amount of money if you choose to click through one of my links at no additional cost to you. If you do, THANK YOU. I greatly appreciate it. If you don’t, no sweat. It’s more important that you learn about personal finance. See my disclosure policy to learn how I’m working to be transparent to my readers on any conflict of interest.

Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.

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    Eight thoughts on Are You An Overtaxed Investor?


    1. I’ll have to pick up this book if they have it at the library (I’m way too cheap to buy books). Some pretty smart thinking there, and really like that line about how a tax-deferred is a tax not paid. I’ve had some people tell me that saving pre-tax isn’t all that great because it’s going to get taxed one day. I never really thought of a good come back other than saying you’re saving money now, but making money on the “float” is a nice way to think about it.

      1. The other thing about “a taxed delayed is a tax not paid” (which I should give all credit to my tax colleagues) is to remember that the tax landscape is always changing. Chances are near 100% that in 20-30 years, the tax laws will be very different from how they look today. It’s the nature of public policy and shifting priorities. By delaying your taxes into the future, you open up the possibility of taking advantage of future deductions or even future tax-deferring moves, that’s why I think it’s smart to take advantage of as much pre-tax savings as you can. Trust that your future self will find ways to successfully minimize taxes in the future using whatever means are available.

    2. Phil and I would get along swimmingly.

      Long before this book was published, I had emerging markets and small cap value funds in my Roth (also REIT). I long for a no-dividend fund in the taxable account. I recently invested in Berkshire expressly for the advantageous zero dividend. The fascination with dividends among investors boggles my mind.

      Cheers!
      -PoF

      1. It boggles my mind as well.

        I’ve thought about putting some money in Berkshire as well, given my great appreciation for Buffett and the zero dividend advantages, but I’m not sure Berkshire will always maintain the policy after Buffet leaves and don’t want to be in a position where I have large capital gains in 20 years and no realistic way to exit without incurring capital gains taxes.

    3. Eliminating/reducing taxes on investments is pretty poor policy, if you ask me — reducing such taxes would be regressive in that only the top percentiles in net worth even pay much of anything in investment taxes, and thus tax cuts on investments would (for the most part) accrue almost exclusively to those with large invested assets (i.e. your Walton heirs, hedge fund billionaires, etc.) who already pay next to nothing in income taxes/Social Security/Medicare taxes (since many don’t get paid “wages” but instead get much lower taxed dividends/capital gains, etc., or make a great deal in excess of the SS limit).

      I’d much rather see tax cuts on wages (specifically ones that would help the lower/middle class, like a massive increase to the personal exemptions/earned income tax credits), higher short term capital gains taxes (to discourage speculative trading), financial transaction taxes (again to discourage speculation and reduce volatility), and maybe a 0% capital gains/dividend tax window on some certain amount ($100k), with every penny above that taxed as regular income. That, to me, would be more progressive/fairer….but, then again, I’m a hopeless liberal.

      1. The counter arguement is effectively the returns on investments in companies are double taxed, once as income tax on company earnings and once on the dividends or capital gains. Just something to think about…

        I’m not sure I agree with the position hat the mutual fund or something like it is on the way out. I personally distrust and avoid target date funds. I see myself doing e same with some sort of targeted fund to me. I don’t want anything that lacks transparency, costs more then the bare minimum, or involves someone or some thing selecting for me.

        1. I think Phil’s argument, which makes sense to me, is not that a fund will be targeted to you, but that you’ll be able to craft your own fund with exactly the allocation you want. Given the overhead costs of having computers handle everything, I doubt it’ll cost very much. So if I’ve decided on a 70 / 20 / 10 allocation, I can either buy three separate index funds to achieve it, or I can just customize this in my Vanguard portfolio. If I want to tilt toward real estate, small cap, etc., I can do it by adjusting other settings.

      2. I hear you chadnudj. As a liberal myself, I often find myself voting to increase my own taxes. That said, I want to legally minimize my taxes within the current tax regime and make smart decisions calculating the impact of taxes on different choices. In that vein, I didn’t read Phil’s book about being an “overtaxed” investor as meaning that taxes are too high and should be lowered on investments. Instead, I read it as an investor who is unintentionally “overtaxing” himself by making certain decisions without the full knowledge of the tax regime. The most obvious answer here being an investor that forgoes contributions to a 401(k) and puts everything in a taxable account. Unfortunately, it’s usually not that obvious and a prudent investor needs to spend some time understanding the tax implications of their various investments.

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