I have a plan for earning $1,000,000 either completely tax-free, tax-deferred or a little of both. The particulars of my plan are totally irrelevant to you - everyone's life choices and financial goals are different. On the other hand, there might be some general concepts that resonate with you. After several years of writing for Seeking Alpha, I've found that you can never really never know in advance whether you have information that could end up being useful somehow for someone else.
There are four main steps to my plan.
(1) A penny saved is a penny earned, but unlike a penny earned, a penny saved is not taxable income. Suppose you are in a 25% income tax bracket. Saving $1 will put you farther ahead than earning $1.32. Every time you save $1, you're automatically earning a "boost" equal to 25% (assuming that's your marginal tax rate) multiplied by that $1. If you invest that $1 and generate compound returns, that little 25% boost will proliferate over time like mushrooms on a dead stump.
Three years ago, I moved with my family from the Washington DC area to Lisbon, Portugal. This move enabled us to save on living expenses and to avoid a layer of state and local income taxes as well. Portugal offers a ten-year tax holiday on most types of foreign source income for new residents, so we didn't pick up any added tax liabilities by moving here. The main savings we've enjoyed since moving here are as follows:
Healthcare costs. In the USA, we would be paying about $1,700 a month in health insurance, whereas we pay about $250 a month in Lisbon. Our prescription meds here cost a tiny fraction of what generic brand prescriptions in the USA cost. We have no deductible on our health policy and our co-pays are lower as well. Our healthcare savings come to about $20,000 a year... tax-free.
Property taxes. We own an apartment in Lisbon and pay property taxes of about $140 a year. I can't say for sure because we had been paying about $250 in property taxes, but last year we received a property tax refund check from the Portuguese government. In DC, we owned a home and paid nearly $10,000 a year in property taxes, and property tax rates have only gone higher and higher since we left.
We also save on upkeep expenses. With our house (built in the 1930s), we were constantly fixing things and hiring electricians, plumbers, roofing guys. Our maintenance costs in Lisbon are roughly zero - which is interesting since our apartment is located in a 400-year-old building (which has managed to survive earthquakes, fires and a tidal wave). Overall, we save at least $20,000 a year in housing costs... tax-free.
Education. Private school in Lisbon goes for about $14,000 a year, compared to $26,000 a year in the DC area. We save about $12,000 in education costs... tax free.
State and local income taxes. We earn about $150,000 in dividends in our taxable accounts. State and local income taxes typically apply regardless of what type of income you earn - qualified dividends, salaries, interest, rents. By living abroad, we save about $11,000 a year in State and local income taxes. And those tax savings are also tax-free.
Overall, we save about $63,000 a year by living where we do. This is literally no different than receiving a $63,000 check in the mail completely tax-free. The key to take away is that we invest those savings regularly, enabling those $63,000 a year checks to compound and throw off even MORE income. The potency of compound savings growth cannot be overstated. If we can invest our $63,000 living expense savings each year and allow those savings to compound at 6% for ten years, we will end up with $830,390 of tax-free money.
I know what you're thinking. What about the income tax on the 6% returns we generate on those savings? Doesn't that 6% investment income get taxed? Funny you should ask. I'll get to that later, when I tell you about my third step.
Now unless you plan to move to Portugal, the particulars of my savings plan are entertaining at best (or otherwise useless). The general point I'm making is that pruning expenses and reinvesting the savings will turbocharge ANYONE'S plan to earn tax-free (or mostly tax-free) income.
(2) Part two of my plan is to be positioned so I can take advantage of the tax benefits from any residential real estate capital gains. In the USA, married couples can exclude up to $500,000 of capital gains on the sale of a principal residence (subject to various requirements). For expats who own a primary residence abroad, the situation is more complex due to the impact of local tax and applicable income tax treaties between the USA and wherever you happen to own a home.
At the time you buy your primary residence, you have no idea whether the price for the residence will go up, down or sideways in the future. What you do know is that the moment that deed is signed, you will receive a call option from the U.S. government with no expiration date and with a settlement price equal to $500,000 multiplied by your future income tax rate. When you sell your house, this call option may or may not expire worthless (depending on whether your house ends up selling for more than you paid). You might even lose money when you sell your home. Either way, make no mistake about it. That free call option from the government has quantifiable value (just ask any options trader) the moment you buy your residence.
Better yet, the government will keep writing you NEW tax-free call options each time you buy and sell your primary residence (subject to various restrictions). Take my case, for example. I sold an apartment in New York City years ago and claimed a chunk of tax-free gains. I put some of those gains into ETFs (which I still own today), put some into a house that I later purchased, and in the fullness of time, I sold THAT house at a gain and claimed a second round of tax-exempt income.
I don't have any plans to sell our current residence, but if and when I do, there might even be a third round of tax-exempt gains. Think about it (and set aside the wrinkles of owning real estate outside of the USA). Assuming that I claim the full $500,000 exclusion on gains from each of these three properties, and assuming I'm in the 37% tax bracket each time I sell, Uncle Sam would be giving me $550,000. For free.
But wait! There's more!
The tax-exempt gains from the sale of my apartment in New York City that I invested into ETFs have been compounding dutifully over the last 17 years as well. I estimate that my tax savings from that sale have grown by nearly 188%. If I was in the 37% income tax bracket in 2001 and claimed the full $500,000 exemption on gains from the sale of my apartment, I'd have saved $185,000. But that was back then.
Today, those tax savings from that sale would have exploded to $532,800 of free money from the government. Tax freebies are fun when you receive them, and even more fun if you save and reinvest them. That is why we saved all of the tax-free gains from the sale of our house, and will let the tax savings grow over time.
I have no idea whether we will earn gains or losses on our current primary residence, but I figure that it's a "can't lose" situation. Maybe we will sell our current residence at a loss, but we'll still get to live in a nice place that we enjoy. Plus, we are saving money by not paying rent. And we don't pay tax on the money that we save by not paying rent, and we can (and we do) reinvest those savings as well.
The bottom line is that owning our own homes over the years has been one of the single most useful tools for generating tax-exempt wealth. I'm not qualified to offer you tax or investment advice, but I can say that if you are ever struggling with the decision to rent or own, consider the imputed savings from not paying rent, and by all means, factor in the value of receiving a free $500,000 tax-exempt call option with no expiration date from Uncle Sam.
(3) Part three of my plan is to generate tax-free investment income. Since I have to pick a number to give an example of my strategy, suppose that I wanted to churn out $135,000 of investment income completely free of income tax. Here's my plan.
I hold most of our highest-yielding retirement assets in ROTH IRAs. Not only that, I allocate portfolio assets based on whether I hold them in a taxable or a nontaxable account. For example, I hold a number of REITs in my ROTH IRA. These REITs do not pay corporate level income tax, and pass through most of their taxable income to shareholders. Since I hold the shares in ROTH IRAs, I pay no taxes on that REIT income at the shareholder level, so there are multiple levels of tax-efficiency that translate straight onto my bottom line. I typically earn between 5% and 6% a year in distributions from these REITs, which I use to buy more shares so that the distributions grow at a compound rate... completely and permanently tax-free (unless the tax rules change).
Let's suppose that my ROTH IRAs generated $10,000 in dividends a year. In this example, I'd be left with $125,000 in dividends and distributions that are potentially taxable. Here is what I do next to bring the tax bill on all this income down to zero.
First, my wife and I claim the standard deduction which shields the first $24,400 from income tax.
Second, for 2018, the first $77,200 of qualified dividend income carries a marginal tax rate of zero. That $77,200 stealth tax exclusion would be consumed by other income types besides qualified dividends and capital gains. For example, if I were to earn $10,000 in interest income, only $67,200 worth of qualified dividends would come in at the 0% marginal tax rate. That would be a double whammy, because I'd not only pay ordinary income tax on that $10,000 of interest, but would also LOSE a $1,500 tax benefit on the qualified dividends that get crowded out of the 0% income tax bracket.
That is exactly why I avoid owning assets in our taxable accounts that generate ordinary income or non-qualified dividends.
Third, capital loss harvesting. I own some shares of ETFs, which I have bought at different times over the years. The tax basis in my ETF shares is all over the place, but when I see that some lots of my ETFs are trading at a loss, I will sell those shares with the highest tax basis and buy shares of similar ETFs with the proceeds (that way I can avoid the wash sale rules that would otherwise disallow me from claiming those losses.) I can use up to $3,000 of capital losses that I've harvested to offset other income besides capital gains.
So far, these three strategies leave me with $114,600 completely tax-free coming into my taxable accounts. Let's keep this party going!
Fourth, return of capital distributions. In some industries with high depreciation costs, companies with substantial free cash flow actually show no earnings and profits. As a result, when these companies distribute some of that free cash flow to shareholders, the distribution is treated as a tax-free return of capital. Some examples are companies like Oneok (OKE), Kinder Morgan (KMI) or Triton International (TRTN). Suppose I invest in enough ROC generating assets in my taxable account to produce $10,000 worth of distributions.
These four strategies would leave me with about $10,400 of dividend income that is potentially subject to US Federal income tax at a rate of 15%. The tax would come to $1,560 a year... EXCEPT for the fact that we can claim a $2,000 tax credit for our kid. Wiping our total tax liability on all this investment income to zero.
There you have it. $135,000 of tax-exempt investment income year in and year out. Between that, the free tax-exempt call option on my residence, and my living expense savings, I'd hopefully be well on my way to eventually booking $1,000,000 of tax-free income. There's just one more thing I can do to hurry along towards that goal.
(4) The last part of my plan is to rely on tax-deferred (or potentially tax-free) capital gains on investments. As long as I don't sell appreciated assets, the capital gains will enjoy tax-deferred status. If I keep the positions until I die, then under current law, the capital gains will permanently escape taxation and my heirs will take a stepped-up basis in the stock equal to the price for the shares on my death (depending on tax elections the executor of my Will makes).
After practicing trusts and estates law for many years, I can tell you from much first-hand experience that Section 1014 of the Internal Revenue Code is the source of absolutely mind-boggling amounts of permanently tax-exempt capital gains. Dying is one of the smartest tax strategies around.
How will I generate non-realized capital gains on my portfolio? Naturally, I have no control over market prices so I can't assume when or whether the gains will ever materialize. The best that I can do is to take my best shot, which will be a function of doing what I've already been doing for the past 20 years.
My investment approach focuses squarely on compound earnings growth. I look at the earnings per share for each company I own, I multiply that by the number of shares I own, I add it all up and can then see the overall earnings per share for my entire portfolio.
My portfolio is essentially a multinational conglomerate, and I'm like any CIO. My job is to grow the overall earnings per share for the overall portfolio. I do that in three ways: (1) I only invest in companies that do a good job growing their (and therefore, the portfolio's) earnings per share, (2) I reinvest savings and allocate capital into more businesses at the best prices I can find and (3) I occasionally reallocate capital away from stocks that trade at high multiples and reinvest the proceeds into similar quality companies trading at lower multiples.
My overwhelming bias is to avoid selling anything for any reason - particularly if doing so would result in capital gains taxes that could otherwise be avoided. I might sell expensive shares of a company as a result of the company being taken over or bought out, for example.
I will most likely sell any company on the spot for engaging in illegal or fraudulent activity, and I will likely do so immediately and irrespective of the share price. Absent those sorts of circumstances, I'd much rather hold the stock. To the extent that I ever willingly sell stock, I'm far more comfortable selling highly appreciated, expensive stocks if I hold the shares in a ROTH IRA and won't attract any capital gains taxes.
Over time, my experience shows me that the price for the portfolio tends to track the portfolio's overall earnings per share growth. If any of you read my blog series on model portfolios over the past few years, you probably noticed exactly the same thing. To be sure, the price for the portfolio twists and turns violently each day (or each year) for any reason or for no reason at all. But in fact, these violent twists and turns in stock prices are exactly why I mostly choose to buy individual stocks instead of diversified index funds.
You see, silly price swings in the market have left me convinced that stock prices are at least partly driven by mania, or trading momentum, or blind indexing - factors that have NOTHING to do with earnings. Does the intrinsic value of a business change much on any given day? No. Can the stock price swoon or soar 10% on any given day? Happens all the time... and that's the niche I want to exploit. So if Donald Trump issues a nasty-sounding Tweet about Lockheed Martin (LMT) or Amazon (AMZN) and the stocks tank, I see it as an irrational knee-jerk reaction and I step in to buy more shares.
If Philip Morris (PM) misses revenue estimates one quarter and the stock crashes, I buy more shares because in my mind, a single quarterly report says absolutely NOTHING about the long-term intrinsic value of a business. Something I don't understand is happening in the world of Italian politics, and as a result, shares of LVMH (OTCPK:LVMUY) were down hard yesterday. Do you really think that the vicissitudes of the Italian sovereign bond market will make people drink less Moet champagne? I doubt it (and in fact, maybe those vicissitudes will make people want to drink MORE). I bought more stock in LVMUY yesterday.
Sometimes it takes years to find out whether I outguessed the market or not. This too is a niche I'm looking to exploit, for unlike a professional fund manager, I can afford to wait for years or even decades to find out if I was right, or if I acted like an utter moron (which happens sometimes and which costs me money every time). Patience is probably the only edge that individual investors like me have in the single-most competitive asset market known to man.
The value of that edge cannot be overemphasized. Professional fund managers fight like crazed hyenas over a quick and extremely hard-to-come-by 10% or 20% return, whereas individual investors can sit back in their rocking chairs for 20 or 30 years and capture a 1,000% return. 1,000% returns are almost impossible over the short-term, but become increasingly likely with the passage of years (as long as it's a well-managed, profitable business).
Not only is time the friend of the well-managed, profitable business, it's an indispensable ingredient of the truly exciting 1,000% investment returns. A 10% daily pop in an expertly (and luckily) timed stock trade looks wimpy and lame by comparison, and I'm very content to avoid playing in that short-term trading sandbox.
Did I ever tell you about our cat who was ominously named "Muffin." Once, Muffin found a mouse hole once at a beach house we were staying at, and she camped in front of that hole with unwavering attention. She didn't move. In fact, she didn't actually do anything. She just sat. Hours and hours and hours. Sitting. Watching. Tick tock, tick tock, tick tock. Then the sun went down. Then the mouse finally came out. Then Muffin bit off its head.
Pure investment genius. And oh.... so, so, so effective. Any professional fund manager with even 1/10th the patience and perseverance of Muffin would get fired for not doing enough... and too bad for him or her! No mouse heads for YOU.
What do I specifically invest in, and how do I pick investments?
First let's discuss the "how" and then get to the "what." As trite as it may sound, I want high quality at a reasonable price. What's a reasonable price? I take a weighted average of the last 5 or 10 years of earnings, and pay less than 23 times those average earnings, depending on the company's earnings growth. I make exceptions, though. What if the company has changed in a material way over the past 10 years? In that case I might only look at the most recent 3 or 4 years of earnings.
I make exceptions to my investment criteria based on random life observations. I was in Thailand recently and noticed a demographic explosion: wealthy young professionals there are seemingly obsessed with owning only the most recognizable luxury brand names. Watching that tidal wave of young, urban money exploding through the doors of the mega luxe shopping malls of Bangkok has everything to do with why I bought more shares of LVMH yesterday (in spite of the stock's nosebleed-section P/E ratio). Humans can still see things that give us some advantages over computer trading algorithms, and while that remains the case, I'm very comfortable taking my reinvestment strategy off a purely numbers-based autopilot.
What's a "high quality" business? To my way of thinking, it's a business with a mix of some or all of the quantitative and qualitative factors listed below.
(1) Investment grade rating. Manageable debt and an unquestioned ability to repay it will lower the expenses of the business, and will limit bankruptcy risk. I use a free account at Moody's and I check credit ratings for my holdings on a periodic basis.
(2) High operating margins and profit margins that persist for years and years. The process of compounding THRIVES on a steady influx of cash, so I want to own businesses that can consistently make money with a wide margin for error in both good and bad economies and across business cycles.
(3) Earnings per share that have been rising for the past 5 or 10 years, or even longer. Steady, thriving businesses that can continuously redeploy capital in a profitable way are the perfect harness for the power of compounding.
(4) Rising revenue for the past 5 to 10 years, or even longer. Cutting costs is a great way to generate rising profits, but is only possible to a point. A company that can constantly access new markets and deliver more (and more expensive) products and services has limitless upside potential.
(5) Steady, rising dividends for at least 10 years, but preferably even longer. Retained earnings can tempt managers into expensive follies, such as corporate takeovers that do not make much sense. By contrast, companies with steady, rising dividends must have some discipline when it comes to the company's free cash flow. Nothing says "loyalty to shareholders" louder than a steady supply of checks in your mailbox. Oh, and as far as discipline goes, management understands that taking those accustomed checks away from shareholders will elicit a gentle and soothing response from the stock market... one that compares unfavorably to the reaction of an overly-tired, hungry toddler when you take away his lollypop.
(6) Rising equity per share over the last 5 to 10 years, or even longer. Earnings statements can be misleading. Over time, if a business is really doing as well as the earnings statement says it is, you ought to see an impact materialize on the balance sheet.
(7) Businesses that offer essential (or at least wildly desirable) products and services with locked-in sources of income or very high brand loyalty. Here are some examples. You need to have running water in your house. Probably just one company provides it, and regulators will establish rates to maintain a reasonable return that is neither too high nor too low. That's a simplified way to think about the business model for companies like American Waterworks (AWK).
Another example. If you sprinkle spice mixes like Old Bay seasoning on your grilled chicken, I bet that you won't consider competing brands and that you will replace your tins of Old Bay seasoning without even looking at the price. You might not even consider eating chicken WITHOUT Old Bay seasoning. This is the sort of brand loyalty that gives companies like McCormick (NYSE:MKC) an edge. Another example: the US government needs to rent office space, court houses, buildings, rarely moves out of a given space once rented, and always pays its bills in full and on time.
Companies that rent buildings to the Federal government enjoy a potential for contractually guaranteed streams of rental income that are likely to be very sticky over time. Easterly Government Properties (DEA) is a relatively new company that has seized on this particular opportunity with a high degree of success. These are all timeless products and services with low risk of the consumer deciding to substitute away from or forego the product.
(8) High quality services and products. I picked up an Apple laptop the other day. It was rigid, lightweight but substantial-feeling, and attractive to look at. The Microsoft laptop I picked up next was made of thin plastic that sort of drooped when I held the laptop by one corner, and the whole thing felt like it would break. It is no accident that I own shares of Apple (NASDAQ:AAPL) but not shares of Microsoft (MSFT).
(9) A proven and obvious leadership position in company's marketplace for at least 5 to 10 years. Quantifiable advantages aside, proven leaders are oftentimes the obvious household names. Amazon (NASDAQ:AMZN) leads e-commerce. Google leads online search (GOOG) (NASDAQ:GOOGL). Visa (V) and Mastercard (MA) are THE credit cards that are most widely accepted around the Earth. These are just a few examples of the obvious market leaders that are so far out ahead of the competition, it would be extremely difficult for any competitor to come along to dethrone them.
Better still, these market leaders earn market-leading earnings and earnings growth. Alas, the obvious market leaders typically carry exceedingly high stock prices - sometimes which turn out to be justified, other times, not. I've found that the best time to scoop up these top-shelf stocks is during protracted, sickening global stock market panics where other investors are selling anything and everything regardless of price. What glorious, happy times are those.
(10) Difficult-to-replicate cost advantages. Railway lines are no longer being built, and the companies that own them can transport goods at a minuscule fraction of the cost that trucks or airlines must charge in order to cover costs. Companies like Canadian National Railway (CNI) and Norfolk Southern (NSC) are examples of businesses that enjoy limited competition thanks to their unique, non-replicable infrastructure and can undercut competition due to the astounding fuel efficiency of modern trains.
(11) Something special that makes you sit up and say "okay, now I get it." There is no formula for this. Example. I can't sell shares of certain ETFs I own because of the massive built-in tax gains. Thanks to this frustrating fact, it finally dawned on me that BlackRock (BLK) owns one of the largest sources of locked-in management fees in the history of the stock market. Another example. I walked down to the Nespresso store in Chiado yesterday to buy more Nespresso coffee pods that cost over .50 cents per pod.
I don't mind paying that, though. The coffee is good and the pods are extremely convenient to use. When I walked into the Nespresso store, I saw that they now offer coffee pods specific to Portugal, and have some Portuguese-inspired products like cups that look like old tiles.
The store is smack in the middle of the busiest tourist section in the city, and people were just streaming in to buy location-specific items. There are comfortable leather chairs, attractive lighting. You feel like those overpriced Nespresso pods are luxury items... a bargain at just .50 cents! It costs a lot less for Nestle (OTCPK:NSRGY) to make those pods. No wonder the business has such impressive earnings.
The more "something specials" you can find, the better. It can be hard to recognize these factors since by definition, you don't know what you're looking for until you find it. That is precisely the reason to look, because thanks to the undefined nature of "something special", there exists no meta data or trading algorithm that can spot it the way a human individual can.
How do I find companies that fit these criteria? First step: I use a stock screening tool available for free on sites like Yahoo, or at a discount brokerage. I enter in the quantitative criteria outlined above. Next, I skim through the results and see which companies have the qualitative factors that I just mentioned. Whether the qualitative factors are there is a question that might not be obvious at first, so I skim through annual reports and shareholder presentations to get a feel for the business.
I compare what these annual reports say from one year to the next. It's better still when I gain access to industry magazines. Third-party research is the last step in terms of sources I like to consider before buying a company (I gravitate particularly towards sell-side research since the vast majority of what I do is to buy and not sell stocks). I would almost say that the best reason to buy a stock is if I can't talk myself out of buying it no matter how hard I try.
Once I find a number of businesses that suit the qualitative and quantitative criteria, I verify whether the stock price is reasonable relative to the companies' prospects for earnings growth. I avoid high PE ratios because they indicate high expectations, enthusiasm, excitement, confidence and (in the parlance of Wall Street) "high conviction." There is no greater portent to a 50% loss than the words "high conviction stock pick." By contrast, over the years, I've found that pessimism, gloom, uncertainty, and boredom (and the low PE ratios that come with it) can produce very comfortable returns at meaningfully lower risk.
I don't want my portfolio to look or behave like a Ferrari... more like a mule hitched to a wagon that just steadily plods along through the rain. Surprisingly, that dingy, smelly old mule wagon can end up miles and miles ahead of the Ferrari in about 10 or 20 years.
The last step in the process, after I ascertain investment opportunities that fit the criteria described above, is to avoid putting myself in a situation where I might become a forced seller during a market panic. I have no debt, I live an inexpensive lifestyle relative to my income, and I take pains to invest in a diverse list of companies that are reliable dividend payers. If patience is the key to successful investing, then the abrupt need to sell is an investor's greatest enemy (shortly followed by the emotional desire to sell when prices are falling).
Now let's discuss the "what." Or better yet, let's skip that discussion entirely and just see the list: $1m tax-free (or at least tax deferred).
This is the list of individual stocks I own in roughly the proportions I own them in. Of course, the portfolio has changed over the years and will continue to do so. There are plenty of positions I would rather not own (including a fairly large position that I have omitted since I plan to give it away), but that I'm stuck with for tax reasons. Some positions are small, experimental positions in companies that I think are especially risky, expensive, or that I don't know much about. Accordingly, nothing on this list is an investment recommendation (which I'm not even qualified to give, anyway).
How long will it take for me to earn $1,000,000 tax-free (or at least tax-deferred)? Hopefully, by now it's clear that isn't the point of this article at all. Given all the uncertainties and things that I can't control, it would be really silly for me to say that I "plan" to earn $1,000,000 tax-free (or at least tax-deferred). The best I can do is plan to save and invest in a way that makes this outcome slightly more possible than it might otherwise be.
I aim to be like Muffin the cat, consistently waiting at the mouse hole for hours, days, or even years if that's what it takes. As an investor, I admire her ability to soldier on through boredom and monotony towards her mouse-laden goals. However, I give more thought than she would to the tax consequences of catching mice, and to the long-term benefits of allowing the mice to compound.
Disclosure: I am/we are long DVY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long every single position listed in the attached chart. I am not an investment advisor, I am not a tax advisor, and I am not qualified to give any investment advice or suggestion, or any tax advice. Nothing in this article, or the attached chart, can be relied upon by any person for any reason, and no statements contained in this article have been verified for factual or even theor accuracy.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.