Do You Invest In Fantasy Land?


We have a 2 year old daughter.  We live in a world of make believe.  We live surrounded by unicorns, friendly monsters, talking animals that play in a treehouse and of course magical princesses and singing, dancing snowmen. Watching the imagination of a 2 year old is incredible.  Playing make believe is more fun than I could have ever dreamed before having a child.

When it is not fun playing make believe is when dealing with a financial advisor who feeds you line after line of half truths.  They come in with fancy print outs with graphs and figures on glossy paper.  Fund A returned 10% last year.  Fund B an even better 16%.  Blah, Blah, Blah!  These numbers are no more real than Sesame Street or the magical “Frozen” kingdom of Arendelle.  When we sat with our advisor year after year and he presented these numbers, we never considered the effect of comissions paid to the advisor, which are not factored into these fantasy paper returns.  We never factored in the opportunity cost of the excessive income taxes we paid by not fully taking advantage of tax deferred accounts as we demonstrated here.  We never considered that the money was not really ours because it was subject to surrender charges as we showed last week.  But at least after all of that, we were getting these returns that we saw on paper on our remaining money, right?  NO!  Actually there was still another layer of make believe.

When investing in taxable accounts, you also have to factor in the effect of taxes on the investments on an annual basis.  When planning for early retirement, unless you have access to unusual tax advantages, you are limited to the total amount of money that you can shelter in work related accounts and/or traditional or Roth IRAs.  Therefore, you will likely have to invest in taxable accounts, so you have to understand how these investments are taxed to make the best decisions for a real world scenario.  Unfortunately, we can’t live in a fantasy land where taxes don’t matter.

For an aspiring early retiree, this process is pretty simple.  Unless you reach financial independence by extreme frugality, you must make a decent to high wage for a short time to accumulate the capital to support you for a long period in retirement.  During these working years, your investments will be taxed at a higher rate because of your higher income.  During retirement, you will have lower or no income meaning that your investments will be taxed at a lower rate (as low as 0% on long term capital gains for those with a low income).  Therefore, just as you want to defer as much tax as possible in 401(k) and tradtional IRAs so that you can pay them at a much lower rate later, you want to push back any taxes on investment income that you can until this time when you will pay a lower tax rate.

The first step to avoiding taxes on your investments is to understand the different ways that you can make money and how each is taxed. Then you can develop an investment approach that allows you to keep as much of your investment return as possible. Remember, the numbers on paper are fantasy. What you actually keep after ALL taxes and expenses are factored in is really the only thing that matters in the real world.

Your investments can make you money in essentially two ways.  First, they can produce income.  This can come in the form of interest on bonds, dividends on stocks, or capital gains distributions.  Any time you have income it is subject to taxation.  The other way you can make money from an investment is to buy something that you expect to go up in value and hold it.  As the value goes up, your net worth is going up.  However, because you aren’t realizing any income, you don’t pay any tax on this unrealized increase in value.  You will eventually have to pay tax on this increased value when the investment is sold.  However, at that time you will need the investment income since you are no longer earning enough income to support your expenses.  Since your income will be low or none, your investments will be taxed at a more favorable rate at that time.

Let’s look at an example that we didn’t truly understand until managing our own investments.  Last year, we held an actively managed mutual fund in our taxable account, sold to us by our former advisor, called the Columbia Contrarian Core Fund.  We also held an almost identical amount of money in a passive index fund called the Vanguard Total Stock Market index fund that we chose.  If you click on the links to these two funds in side by side windows you can see that Morningstar rates each as 4 Star funds.  You can see that in a few of the years the managed fund outperformed the index fund and in others, the index fund was better.  One fund is not clearly better that the other over this 5 year period of comparison right?  In fantasy land, that is correct.

Well, that actually is not correct because in the real world the Columbia fund was purchased with commissions of up to 5.5% and the Vanguard fund is no load.  This is not factored into these performance numbers which reflect fantasy land.  Let’s ignore that for now for an apples to apples comparison of the money left invested.

Last year our actively managed Columbia fund returned 12.66%.  The fund produced income in this way:  Dividends $135.80, Short-Term Capital Gains $210.79, Long-Term Capital gains $1,630.27.  The remainder of the gain is increase in value of the fund, which is not taxable.  The tax rate is based on your income.  We owe 25% on any short term capital gains or $52.70 and 15% on dividends and long-term gains or $264.91 totaling $317.61.

The index fund returned an almost identical 12.56%.  We earned $496.64 in dividends and had $0 capital gains.  We owe tax of $74.50.  We owe over 4X the taxes on the active fund we do on the passive index fund.

In fantasy land, the funds were essentially equal.  After taxes, the index fund had an advantage of approximately 1%. In actual dollars this looks small.  Remember, I was comparing only 2 relatively small investments (approximate $30,000 each). To retire early requires at least 6 figure investment accounts meaning an extra tax drain of THOUSANDS OF DOLLARS EVERY YEAR.

Don’t be confused and think that the active fund is bad just because it is taxed more heavily.  What we care about is how much money we actually keep in the real world, which is simply the total return minus expenses and taxes.  We don’t want to be cheap and choose a bad investment just because it has low expenses and/or low taxation.

Extensive research shows that index funds have a greater than 80% chance of outperforming actively managed funds over time BEFORE TAXES.  That is comparable to the odds in a casino of the house vs. the average gambler.  The extra percentage advantage of taxes only shift the odds even further in our favor.


When I am playing with this money it is fantasy land.  I don’t mind being the gambler.

However, I live and invest in the real world.  I want to be the house.

*Thanks for reading. If you enjoyed this content, you can find my current writing at Can I Retire Yet?. Enter your email below to join our mailing list and be alerted when new content is published.

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