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Thursday, June 3, 2010

Taxes,DIY Investor, Milevsky

Homework time!

All DIY Investors need to read chapter 5 of "Your Money Milestones" by Moshe A. Milevsky. Actually, the whole book is worth reading because it's well written and presents a unique look at financial planning. He believes in smoothing lifetime consumption. He tells of an exercise where he asks his students to do a mocked-up personal balance sheet. These, of course, are pathetic and done wrong because, according to Dr. Milevsky, they don't include human capital. Dr. Milevsky explains to the students that they are like an oil well with a stream of earnings forthcoming over the next 40 years years or so. This stream of earnings based on their human capital needs to be taken into account on their balance sheet.

In the tax chapter he presents a typical approach of thinking of Uncle Sam as a business partner and the need to ensure that Uncle Sam doesn't take too big a cut of earnings. He talks about an anomaly that drives economists up a wall - the preference of low income individuals to give Uncle Sam an interest free loan and receive a big tax refund in April.

The part DIY Investors need to understand has to do with mutual fund returns reported for taxable accounts. Assume we see a 10% return for the year. I quote:

  • "The entire 10 percent might be due to interest or dividends received, or both, even if the underlying securities themselves didn't increase in value.

  • Alternatively, the stocks and bonds in the fund might have increased in value without being sold, and in addition, they earned some dividends and interest.

  • Finally, the return might result from the investments themselves being sold for a profit.

  • In each of these instances the bottom line amount for the DIY Investor is going to be different. Thus, returns of actively managed funds are not always what they seem.

    All of this is just further reason to prefer low turnover, low fee indexed funds.

    1 comment:

    1. I've had many unpleasant December capital gains surprises in my mutual funds. In some funds, though I have a nice profit, my cost basis actually shows a loss because of these distributions, which means the fund has distributed more in gains to me during the time I've held it than it has appreciated in value. Very irritating that I get the tax hit for appreciation that occurred even before I bought into the fund. But the taxman likes it this way.