tax_man2.jpgToday's rude question: When does your money manager cost more than the taxman?

Answer: Sooner than you think.

If the idea of comparing a money manager with the tax collector sounds a bit perverse, let's examine some basic realities.

When we earn income, the taxman stands between us and our income. Before we see a dime, taxes are taken from our paychecks. What trickles down to us is a good deal less than what we earned.

Today, federal income tax rates range from a low of 10 percent on the first $7,825 of taxable income on a single return ($15,650 joint) to 35 percent on taxable income over $349,700 on a single or joint return.

Relatively few get to complain about paying at the 35 percent rate. But, as you'll soon see, a schoolteacher can lose more than that to her investment manager.

When our money earns a return, its manager is like the taxman. He stands, just as Kurt Vonnegut's Sen. Rosewater always preferred, between us and the return on our money. Before we ever see a dime, management expenses are tactfully removed. In the world of managed mutual funds, variable annuities and other widely available financial products, we're often told the expenses are modest.

If you believe that, I will consider selling you a number of bridges that I own, starting with the Mystic River Bridge in Boston.

They aren't modest because most managers don't earn above-average returns. So their expenses reduce the return we get.

Even then, it might seem unfair to compare a money manager to the taxman. After all, if large-capitalization domestic stocks can be expected provide a compound annual return of 10.4 percent, then the average 1.41 percent expense ratio of large blend mutual funds takes only a modest 13.6 percent of the expected gross return.

That's a whole lot less than the taxman takes from most of the people, right?

Wrong.

You and I invest to capture the miracle of compound growth. The annual expense ratio that seems reasonable or modest for a single year reduces our compound return. Over time, it reduces the amount of return we keep. Not by 13.6 percent, but by 25 percent, 33 percent, 35 percent and more--- as much as the taxman collects from the highest-income taxpayers.

Here are a few examples:
  • Schoolteachers have 403(b) plans that are dominated by expensive insurance-based products. They often cost 2.5 percent a year. This expense takes 24 percent of the return in the first year, assuming an index return of 10.4 percent. It reduces their accumulation by 32.6 percent by the 10th year. The reduction is a whopping 42.6 percent by the 20th year. So a career schoolteacher pays an investment management "tax" that is far higher than anyone, at any income level, pays.
  • Employees in medium-size 401(k) plans may pay 1.4 percent in management expenses for their mutual fund choices. They lose a modest 13.5 percent of their return in the first year. The damage rises to 19.1 percent by the 10th year and 26.1 percent by the 20th year. Over a working career of 40 years, management expenses reduce their accumulation by a stunning 40.8 percent--- again, far higher than the highest marginal tax rate.
  • Employees who are blessed with the wisdom lacked by their employers can invest in low-cost index funds in their IRA and Roth IRA accounts. Assuming an average annual expense of 0.20 percent (higher than current costs for such funds at Vanguard or Fidelity), they lose a minuscule 1.9 percent of their return in the first year. The tab rises to 2.9 percent after 10 years and 4.1 percent after 20 years. By the 40th year, their accumulation has been reduced by only 7.1 percent.
Most workers are losing more to the expenses of their managed plans than they will ever lose to the taxman.

If you'd like to see how these differences affect you personally, I invite you to visit my website, www.scottburns.com, and experiment with my new online calculator. It will show you the difference in dollars and as a percent of accumulation between the costs of any two plans you choose.

On the web: God Bless You, Mr. Rosewater

In this Vonnegut novel, the senator's nephew is advised to "get down to the banks of the money river where the rich and powerful slurp."