How Warren Buffett used deferred taxes to make twice as much money

Deferred taxes: "Rip Van Winkle” style of investing yields twice as much money

In the 1989 Berkshire Shareholder letter, Warren Buffett calls his style of investing “Rip Van Winkle” style of investing. What he is referring to is Berkshire Hathaway’s penchant for long-term holding periods in a passive investing style where unrealized gains amass along with growing deferred tax liabilities. Rip Van Winkle in the well-known short folktale was a guy who didn’t do much. Contrast this style of investing with constant buying and selling – what happens tax-wise?

When you buy and sell frequently, you are incurring taxes. But when you buy and hold, your taxes are not taken out until you sell the asset after long periods of time; and they are taken out only once at the end.

But economically what does this mean for the investor?

It means that if you were to buy and passively hold a single investment that grew at 10% per year for 50 years versus buying and selling and paying 20% taxes on the yearly gains with the same or different investment that also grew 10% each year in a frenzied manner, your returns would be markedly different because of the timing of tax payments.

In the first instance, $100 invested would become $9,411 or a 9.51% net annualized return after taxes over 50 years. In the second instance, $100 invested would become $4,690 or an 8.00% net annualized return after taxes over 50 years.

Why does this happen? 

This happens because deferred tax liabilities are a form of financing that add to the pool of assets that are compounding. And the compounding pool of assets grows in your favor. It doesn’t make a big difference at first but after several decades the difference becomes very significant.

Bottom line – you make twice as much money through the passive investing strategy as you would via the active investing strategy over the course of 50 years. 

In the words of Warren Buffett from the 1989 shareholder letter, this form of financing is described as follows:

In economic terms, the liability resembles an interest-free loan from the U.S. Treasury that comes due only at our election…

Imagine that Berkshire had only $1, which we put in a security that doubled by yearend and was then sold. Imagine further that we used the after-tax proceeds to repeat this process in each of the next 19 years, scoring a double each time. At the end of 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government and we would be left with about $25,250. Not bad. If, however, we made a single fantastic investment that itself doubled 20 times during 20 years, our dollar would grow to $1,048,576. Were we then to cash out, we would pay a 34% tax of roughly $356,500 and be left with about $692,000.

The sole reason for this staggering difference in results would be the timing of tax payments. Interestingly, the government would gain from Scenario 2 in exactly the same 27:1 as we – taking in taxes of $356,500 vs. $13,000 - though admittedly, it would have to wait for its money.