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The goal of Tax Planning 101 is to escape tax altogether, forever. As Prof. Edward McCaffery details in The Oxford Introduction to the U.S. Income Tax Code, Tax Planning 101 consists of three steps:

Step One: Buy assets that increase in value without producing a cash flow

In other words, a diversified portfolio of stocks that don’t pay dividends. This is the subject of an entire chapter in my book, The Overtaxed Investor.

Alas, nearly all other investments generate a cash flow, leaving taxes to gnaw away your total returns. The money lost to taxes never compounds to produce greater wealth for you. The financial services industry has set up a conveyor belt that feeds your investment returns to the Internal Revenue Service.

When you buy stocks or funds in a qualified IRA or 401(k), the government is your silent investment partner. It owns the percentage of your account set by your marginal tax rate at the time of withdrawal. As your required minimum distributions ramp up, your dividends and capital gains will be taxed as ordinary income and taxed at your higher marginal rates. This is not Tax Planning 101.

Alternatively, when you buy index funds, mutual funds, or exchange-traded funds in a brokerage account, you cannot credit any of these funds’ internal tax losses against ordinary income or your other capital gains. In a typical down year, shareholders despair and sell their mutual funds. These reckless investors leave the remaining owners stuck with the tax tab they created. Sensible buy-and-hold investors are left holding the bag. Is that fair?

Meanwhile, the dividends in your brokerage account pile up. Once again, the government is your investment buddy. In California, high-bracket investors pay a 36.1% tax on dividends and capital gains year after year. This is also not Tax Planning 101.

Our process starts by screening out all the stocks that pay dividends. We carefully select U.S. companies for the characteristics that academic research suggests are the most desirable to long-term, buy-and-hold, tax-sensitive investors.

Inside your account, as your holdings compound, they do not generate a taxable income stream. Unlike with mutual funds, there is no portfolio churn from active managers or index changes or trigger-happy co-investors to gin up capital gains for you to pay. You have effectively fired Uncle Sam, your investment buddy. This is Tax Planning 101.

This portfolio also works well for children subject to the ‘kiddie tax’. As the Journal of Financial Planning notes, “When a child’s investment income reaches $4,700, consider investments that pay no dividends….”

Your account goes beyond this into Tax Planning 102, because we routinely harvest capital losses on your behalf. You can apply these against capital gains and/or against $3,000 of ordinary income every year. These losses can be carried forward indefinitely.

Will eliminating dividend stocks impair investment performance?

The stocks for this portfolio are selected for investment styles evidencing long-term structural alpha in the academic literature. That said, investors follow fads and there is no guarantee that the short-term performance of these companies will closely follow any market index. Care is exercised in selecting the individual companies, in weighting the holdings, and in timing their purchase to make this an ideal holding for a long-term, tax-sensitive investor.

Step Two (optional): Generating Income from a Zero-Dividend Portfolio

Since your account holds numerous securities, we can cherry-pick the stocks with the highest basis to sell if liquidity is required. Research by Birge and Yang suggests that a portfolio holding numerous assets (but not mutual funds) – even with a cost basis of zero – can be liquidated by 3% to 7% a year and still postpone capital gains taxes for ten to fifteen years.

There is also another option for income. Those seeking liquidity can borrow against their portfolio.

The money you pull out as a loan comes to you tax-free. When you borrow, there is no change to your net worth. The asset (cash) on one side of your balance sheet is matched by the liability (debt) on the other.

Portfolio loans are for sophisticated investors who understand the non-trivial risks of loss. The U.S. stock market lost roughly half its value in the inflationary 1970s as well as in the financial panic of 2008. It lost nearly three-quarters of its value during the early years of the Great Depression, 1929-1933. Clients should keep this market history in mind when weighing a prudent loan-to-value ratio. Conservative Wealth Management LLC does not advise on, supervise or monitor client portfolio loans, leaving the choice of whether and how much to borrow entirely between the client and the custodian.

Step Three: Eliminating Capital Gains

Deferring the tax liability on capital gains allows them to grow undiminished to the investment horizon. This is tantamount to a free loan from the Internal Revenue Service. The larger and longer the deferral, the greater the after-tax benefit to the investor.

Want more? If you leave the assets in your estate, your unrealized capital gains liability disappears entirely. Your appreciated stocks receive a step-up in cost basis. Your executor can sell the stocks and pay no capital gains. Your heirs are free to start the process all over again. Even if the tax code changes to eliminate the capital gains step-up, you will have benefited from possibly decades of tax deferral. Professor William Reichenstein estimates that even over a single decade, the effective capital gains tax rate on stocks might fall from 15% to 11.3%.

As The Oxford Introduction to the U.S. Income Tax Code states, “By buying capital assets that appreciate without producing taxable dividends, borrowing to finance present consumption, and continuing the game straight onto death, the rich can avoid all federal taxes.” Professor McCaffery opines that “any advisor who is not aware of this basic planning advice is committing malpractice.”

Our zero-dividend portfolio is designed to help build generational wealth for your family.

  • A U.S. equity portfolio designed for extremely low (possibly negative) tax impact
  • $10,000,000 investment minimum
  • No capacity constraints
  • A separately managed account held in your name (or the name of your trust or family LP)
  • Regular tax-loss harvesting
  • Convenient 1099-DIV tax reporting; no K-1s