How much is your obsession with tax efficiency costing you?

Something that I find separates me from the classical financial independence/early retirement community is the particular obsession of that community with achieving financial independence in order to retire early from work.

In the framing I see regularly repeated, you’re supposed to study for the most lucrative degree possible, then get the most lucrative job available, then earn as much money as possible and save as much of your income as possible, in order to quit the job you despise as soon as possible.

To me this is obviously nuts: if you’re able to survive on a pittance, why not cut out all the middlemen and simply earn a pittance doing something you actually want to do?

But much more importantly to me, the focus on paid labor means FIRE types tend to put off entrepreneurship until after retirement, or look at it as a means to finance retirement, rather than as a shortcut to the life they actually want to live.

An under-appreciated obstacle to pursuing entrepreneurship earlier in life is the focus on the tax efficiency of investment decisions. I think that focus is a mistake.

The strong case for tax efficiency

One offshoot of the obsession with paid work is the obsession with tax efficiency of the investments made with one’s labor income. I always like to address the strongest possible case for positions I disagree with (partly because sometimes I change my mind!), and the strong case for taking maximal advantage of tax-advantaged savings plans is quite strong:

• The upfront tax savings afforded by traditional IRA’s and 401(k) plans allows your after-tax income to be invested at a higher value than they otherwise would. In the 25% marginal income tax bracket, $1,000 in after-tax savings would require $1,333 in pre-tax disposable income. That same $1,333 in pre-tax disposable income could instead be used to invest $1,333 if directed to a traditional IRA or 401(k) plan. That’s a 33% “bonus” to your initial capital, which will hopefully compound happily for years to come.
• The tax-free withdrawal of Roth assets allows the appreciation on your assets to be withdrawn without tax liability in retirement and in certain other circumstances. A $1,000 contribution compounding at 5% annually for 30 years will produce $3,321 in capital gains. In a taxable account, dividends would be taxed annually and any final capital appreciation would be taxed on withdrawal. Meanwhile rebalancing transactions within the account may produce additional intermediate taxable gains (although they might also create losses).
• Both types of account permit tax-free internal compounding, which both disentangles your total return from the vagaries of your year-to-year tax situation and saves you the hassle of calculating your capital gains tax liability each year, which is not fun.

The simple case against tax efficiency

The simplest way to explain the problem with tax-efficient investing is through the restrictions on what kinds of investments can be made with tax-advantaged retirement vehicles:

• you cannot live in real estate owned by your tax-advantaged retirement vehicles (or receive any other pre-retirement benefit from your investments);
• S-corporations cannot accept investments from tax-advantaged retirement vehicles.

Of course most custodians restrict your investment options even more, limiting you to publicly traded securities offered through their own brokerage platform. My point is broader though: in exchange for the tax efficiency of your investment you explicitly restrict your ability to invest your excess income in your own business.

The best case for investing in public markets is that you don’t have any ideas

I constantly have ideas for businesses, so I find it kind of hard to get inside the head of someone who doesn’t have any ideas for businesses (I occasionally post free business ideas if you’re having trouble coming up with one of your own).

But the most convincing case to direct as much of your disposable income as possible into tax-advantaged savings vehicles is that you think the public markets as a whole, your preferred asset allocation, or even a particular active mutual fund or hedge fund manager will perform better, taking into account the relevant tax advantages, than you will investing in your own business.

In my experience, this intuition isn’t very convincing.

Business is more profitable than you think (but less profitable than you want)

I have a sort of unique position since, on the one hand, my own business is extremely capital-unintensive: I pay a few hundred dollars per year for my web domain and content management system, then I get paid depending on how good people think my websites are.

At the same time, I have a lot of friends who have extremely capital-intensive businesses: buying and reselling merchandise and gift cards. Their overall profit depends largely on the amount of volume they’re able to push through their supply and distribution chains, and the more capital they have to buy products, the higher their profits are.

The reason I raise this juxtaposition is that I think it’s informative about how you should direct the profits from any given line of business. A capital-light business that has a rapidly decreasing return on reinvested capital makes tax-advantaged investment accounts more attractive as a way to boost the returns on the business’s retained earnings. Meanwhile, a capital-intensive business that has a steady or only-slowly declining return on reinvested capital should make tax-advantaged accounts less attractive since once profits are shielded they’re unavailable for reinvestment in the business.

The reason this result should be counter-intuitive is that the capital-intensive business is likely more profitable than the capital-light business! In other words, the more profitable your business is, and the higher your returns are on reinvested capital, the less you should want to shield your profits in tax-advantaged accounts which can only be invested in public markets.

We don’t need tax reform, we need mind reform

Alright, the preceding was a bit pedantic. My unfortunate literal tendency at work, no doubt. But I wanted to lay it all out to make as clear as possible my case for abandoning your obsession with the tax advantages of your workplace retirement plan and finding, as soon as possible, the business that will let you live the life you actually want.

If we want to create a society of entrepreneurs and entrepreneurship, we don’t need to cut corporate taxes, or cut taxes on pass-through income, or accelerate depreciation, or have a tax holiday on repatriated earnings.

We don’t need tax reform, we need mind reform.

We need to tell people that it’s good and right that they leave their jobs to start their own businesses. Every second spent on the potential tax consequences if or when they ever turn a profit, and how to shield that profit from taxes, is time that could be spent on the actual business an entrepreneur is trying to bring into the world. Our economy needs more businesses and fewer workers, and the obsession with tax policy is a major obstacle in the way of that vision.

The reason tax reform can’t be the answer is that even in our current tax regime entrepreneurship is much more profitable than labor. What anti-tax evangelists have done is convince entrepreneurs that the taxes they pay are extravagant, exploitative, and destructive, when they’re nothing of the sort: business is just so profitable that entrepreneurs end up paying more in taxes on their small businesses than they did as employees. That’s because their income is higher as entrepreneurs than as employees.

At the end of the day, no just system of taxation is going to levy lower taxes on entrepreneurs with a given level of income than on employees with the same income. Yet that’s precisely the regime Republican members of Congress are currently trying to implement. I think they’ll fail, and I hope they’ll fail, but your decision whether or not to start your own business should have nothing to do with their eventual success or failure. You should start a business based on the life you want to live.

The taxes will work themselves out. Of course you can decide to withhold your own ingenuity from the marketplace, but the marketplace is going to be fine without you. Will you be fine without the marketplace?