A Very Long Post About Some Basic Investment Concepts

Monday, July 2, 2018

I was going to post a comment in response to this post on a personal finance blog that I had never read before coming across a link to said post, but then I decided I shouldn’t hijack that person’s comment section, I should instead just write my own post. BECAUSE THAT’S WHY I HAVE MY OWN BLOG.

Also this feels appropriate because July 1 (when I started writing this post) would have been my father’s 78th birthday, and I think that my father would have been proud of me for being able to write this post. He was a CPA who was very patient in letting me ask him dumb questions over and over again until things finally made sense. (We had probably 15 conversations about depreciation before I got it.) He also would never just give me an answer, he would send me the Rev. Notice or whatever his answer was based on and have me read it for myself.

This was his approach my whole adult life.

Like for instance in 1992 when I found myself with $3000 that I needed to figure out what to do with. (Despite making around $18,000 a year at my first job in Princeton, NJ, I managed to end up with that amount in a savings account that I needed to close following my relocation to DC/Virginia.) I asked my dad what I should do with it and he told me that before he would tell me what to do, I needed to learn about the stock market. He gave me a list of books to read, one of which (the only one I remember) was The Intelligent Investor by Benjamin Graham. Once I’d read that, he told me, we could talk about it and I could tell him what I thought I should do and he would tell me what he thought I should do.

So I read The Intelligent Investor and it helped me understand the stock market and not be afraid of it. I closed my savings account and with a third of the money I bought a new bike (which I still have, and still ride) and the remaining $2000 I invested in a couple of different mutual funds. Once I started doing my own taxes a few years later, I realized that the Vanguard fund I invested in was far better than the others, the returns were better and the taxes were lower, so I stopped putting new money into the others and instead put all of my monthly transfer into Vanguard.

By the time I bought my house in 1999, I had more than $30,000 in those investment accounts. I bought my house for around $100,000 so I only needed $20,000 for the 20% down payment, and the rest I left in Vanguard for later use. It’s been really great to have that money. I’ve been able to dip into it as needed — for work on my house, to pay off my student loans from grad school, and (in the past few years), to help prop up the nonprofit I work for to avoid fiscal crisis — as well as to have it as “just in case” money that keeps me from worrying about not having any money.

I thank my father every time I look at my Vanguard statement. He didn’t give me any money to put into it, but he gave me something much more important — the education and knowledge I needed to take care of things myself and to make good decisions about money.

Thanks, Dad.

*****

Okay, here’s the post I started to write, which is probably of interest to no one. But I am posting it anyway. Because this blog is not for you, Dear Readers, it is for ME. You’re just along for the ride.

Here goes.

Dear My Money Wizard,

Your post on earning tax-free income was interesting, but it seems to be missing some context. And since you work in finance, I’m assuming you know all of this, but I’m going to lay it out here anyway since I know there are lots of other people out there who don’t.

Here are a few things I noted and wanted to comment on.

1. A dividend is not a “thank you” from a company for buying its stock. You’re not doing a company a favor when you buy stock; you’re providing the company with capital, in exchange for which you are receiving an ownership interest in the company. (Whether you do this by buying an individual company stock or through a mutual fund makes no difference; the concept is the same.)

The company takes the money it earns from the sale of stock and uses that money to make more money. The reason people become owners of a company is to make money; that’s the whole point of investing.

The ownership interest you purchase when you buy stock gives you the right to have a say in how the company is run and the right to a portion of the company’s future profits (should there be any). If the company makes money, you as an owner make money. If the company loses money, you as an owner may lose money. (The amount you stand to lose is generally limited to the amount you invested.)

There are two ways to generate income from investing in a company.

One way is when the value of the company’s stock increases during the time you own it. This allows you to sell the stock for more than you paid for it. The difference between what you bought the stock for and what you sell it for is the amount of gain you make on your capital (i.e., your capital gain). This is what is taxed at the capital gains rate.

Capital gains can be short-term (property held for less than a year) or long-term (property held for more than a year). (Stock is a form of property.)

Through the workings of our elected officials, We the People have decided that taxes should be lower for gains someone had to wait more than a year for than for gains someone got by buying and selling in less than a year. This means that long-term capital gains are taxed at lower rates than short-term capital gains.

Stock prices can also go down.

If you sell a stock for less than you paid for it, you lost capital. For tax purposes, capital losses can be used to offset capital gains. But that would be another very long and very boring post so we’re going to skip that discussion. For now, let’s just assume that you can only make money in the stock market, not lose it. (Yippee!)

The second way that people generate a return on their investment by owning stock is by receiving a distribution of a portion of the company’s annual profit. This is called a dividend. The amount of profit to be distributed is divided by the number of shares outstanding resulting in a per-share amount (e.g., $3 per share). So if you own 100 shares in a company that has a $3 per share dividend, you would get $300.

As noted in your post, “qualified dividends” are dividends that meet certain criteria set by Congress. Again, We the People working through our elected officials agreed that most but not all dividends should get lower rates; others are taxed at the same rate as the rest of your income. (For federal income tax, that is. They are not subject to Social Security or Medicare tax. DIFFERENT POST.)

Got that?

To recap: Capital gains are the income you earn when you sell your stock for more than you paid for it. Dividends are a distribution of income you receive as an owner. These are the two ways that equity investors (owners) make money.

You can also be a debt investor (lender), loaning money to a company by buying bonds. But again, not going to go into that here. Too long, too boring. DIFFERENT POST. This is why the CPA exam consists of four separate 3-hour tests, each of which has multiple testlets (yes, that is an actual word). It just goes on and on.

Okay. Now into the weeds on dividend income.

Let’s say a company has 80 shares outstanding, it has two stockholders who each own 40 shares, and its total income tax rate (federal plus state and local) is 20%.

Further, let’s say that the company’s net profit for the year, after all of the expenses are paid — wages and rent and utilities and the costs to buy/make/develop the products or services it sells and to advertise and sell the products/services and to buy snacks for the staff break room and whatever else the company spent its money on during the year — is $100. With a 20% tax rate, it pays $20 in taxes, leaving $80 in net earnings. The company earnings are $1 per share ($80 divided by 80 shares outstanding = $1/share).

The company can take that $80 and do something with it that it thinks will allow it to generate more income next year — buy new equipment or hire more staff or upgrade the chocolate in the break room from Hershey’s to Callebaut — or it can distribute that money to the owners in the form of a dividend.

In this case, with two owners each having 40 shares, if it distributes all of its earnings as dividends, each owner would receive a $40 dividend.

Typically newer companies keep the money they make to invest and try to increase growth, while mature companies distribute profits to their owners. Retirees and people who are in search of steady income tend to prefer dividend-paying stocks.

Bottom line: Dividends are a return on investment, it’s why people invest, they are not a thank you for buying stock.

Phew.

Okay on to the rest, which is slightly simpler.

2. Some people argue that investment income shouldn’t be taxed at all when distributed to owners, because owners paid tax on that income when the company paid taxes on its earnings. By taxing the income both when it is earned and again when it is distributed, the same money is being taxed twice. (You can read lots and lots on this if you search for information on “corporate double taxation.”)

This argument assumes that the corporation and its owners are a single entity, and that the corporate entity is being taxed both when the money is earned and when the money is distributed. This argument doesn’t quite work for me, because it seems to me that the corporate entity is one thing and the individual owners are a different thing. It’s hard for me to wrap my head around any other interpretation.

But your post seems to go even further by seeing no connection at all between the company and the owner/investor, considering the reduced taxes on investment income as some kind of crazy loophole.

But basically the reduced rates — with lower-income individuals being taxed at a 0% rate — is a compromise between the people who think investment income shouldn’t be taxed at all (because it was already taxed when it was earned) and the people who think investment income should be taxed a lot because it is mostly earned by rich people who can afford the higher taxes and who cares where it came from in the first place or what happened to it before the rich people got it.

3. Your “earn income tax-free” argument doesn’t completely make sense, because in order to execute your plan, you need to make as much money as possible, and that money is taxed when you earn it. (And taxed more if you earn enough to bump yourself into a higher tax bracket.) [Unless you are doing the 401(k)/Roth conversion thing, which I admit I do not understand the details of because I’m not about to do it and it depends on tax laws that may change by the time I ever need to actually know about it so I just skim over anything involving a Roth conversion.] Then you are using this after-tax income to earn more by becoming the owner of a company, and the company you own is paying taxes, thus reducing the amount they have available to distribute to you. So the money isn’t really tax-free — you pay taxes when you make the money you use to invest and then again when the company you have invested in makes money. It’s just that the taxes are indirect, they come out before you see the money instead of being something you pay on your own tax return. But nonetheless they are taxes.

If you really want to earn money tax-free you need to talk to Paul Manafort. You get paid cash for your work and park it offshore then use a shell company to buy a house with the offshore cash then take out a mortgage on the house to get cash in the U.S.. Voila! Cash! No taxes!

Except oops, you can’t talk to Paul Manafort because he’s in jail.

4. Regarding Publication 550 being the most boring IRS publication ever produced, I need to say that as someone who survived getting a master’s degree in accounting at age 48 (which involved, among other things, a class in partnership tax and a class in international tax), and who spent the past two summers studying for and passing all four CPA exams, I find it extremely amusing when PF bloggers read some IRS publication and declare it the most boring or most confusing thing ever produced by the IRS.

I am here to tell you that you have no earthly idea how confusing and/or boring information produced by the IRS can be.

Trust me on that.

****

Okay that’s it.

Congratulations to everyone who made it to the end!

I promise that I will not be producing a tax series. And if you are actually interested in understanding investing, you should go read The Intelligent Investor. It will change your life.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s