Realized vs. Unrealized Income

[inquisitive]

So I've been listening to "The Millionaire Next Door" and it has really piqued by interest in millionaires, although I've had a plan for a while now, but on that program, the author mentions that one of the hallmarks of millionaires is to reduce the realized income and maximize the unrealized income as much as possible, to decrease the amount of taxes, and also mentions that Ross Perot is an expert at this. For the millionaires here, is that correct, and also, how exactly does one increase the unrealized income? For example, if I put a lot of money into the stock market and my stocks go up in price, eventually I'll have to sell it and buy other stocks, so doesn't that become realized income?

What does FIRE stand for? There is conspicuously no FAQ or sticky in both of the forums containing the word FIRE and I did a search and could not find the answer..

Thanks!

[REWahoo]

http://www.early-retirement.org/foru...rum-19058.html

[SecondCor521]

I'm not a millionaire yet, but the author is correct.

The reason for this is that once you start earning any real amount of money, taxes will most likely be one of your top expenses. Although it's not required to be the case, in the US taxes on capital gains have historically been lower than taxes on income. Therefore, when you can do so legally, it is preferable to avoid paying taxes in the first place, pay capital gains taxes in the second place, pay income taxes third, and pay tax penalties fourth. It is from these rules and principles that most of the good financial advice follows.

To your specific questions:

One increases unrealized income, of course, by buying and rarely selling stocks. My father, for example, still owns some AT&T stock that he bought in the 1960s. Or by buying in tax deferred accounts, where the realized income isn't taxed. Or by buying index mutual funds, which can rebalance in tax-advantaged ways.

If you buy stock and it goes up, good for you. If rebalancing means you need to sell, then yes, it will be realized income at that point. Sometimes there are other factors that come to bear -- growing wealthy is eventually not the only consideration. For example, if you buy a stock that grows by 100x, most here would advise diversifying away at least some amount in order to reduce the risk of catastrophic loss. And yes, you will likely pay taxes in that situation.

2Cor521

[headingout]

Originally Posted by inquisitive

if I put a lot of money into the stock market and my stocks go up in price, eventually I'll have to sell it and buy other stocks

Not necessarily. The majority of seasoned investors that I've learned from rarely sell investments. Warren Buffet brags about being "slothful." To maximize your sleep and minimize realized income, research and find investments (whether they be stocks, mutual funds, or whatever) that you are comfortable holding for the very long term. If you play your cards right then during most of your working career you can rebalance towards your desired asset allocation by buying with new cash, not by selling (and paying capital gains taxes). Sure in the very long run you may have to sell some, but if you choose high-dividend investments you may even be able to just live off their income indefinitely.

[inquisitive]

Thanks for the very rapid responses, I think this is going to become a favorite forum! I will get a book from the library on taxes to read up further from your post.

[RunningBum]

I agree with your basic premise. If you're eventually going to sell the stock, whether you did some selling yearly (holding long enough to get LT cap gains) or waited and sold it all at the end, you'll come out about the same. This assumes that the cap gains rate stays the same, and your rate of return is the same.

There are a few caveats. The best one was already hinted at, avoid paying taxes at all. When you die, your estate will be larger if you buy and hold forever and your heirs will get a new basis at the current price. So nobody pays taxes on that gain. Someone correct me if I'm wrong.

By selling more often, you'll have some additional transaction costs, but those should be small.

By holding a long time, if you ever do need to sell (perhaps due to an emergency, or a stock you want to get out of because of some news), you'll be able to sell with LT cap gains taxation. But if you are turning it over more rapidly, you might be caught at a time where you haven't held for a full year, and get stuck with ST cap gains. That could be significant if you are 8-10 months into a good year. There are ways around that (sell an equal number of shares short while holding your shares for the remainder of the 12 months) but there's some overhead expense to that.

I also think one of the messages is to buy quality and hold it rather than try to chase hot stocks.

[rachael24]

Very good points Running...I think the transaction costs may be larger than you think though

[donheff]

When DW and I hit 70, RMDs will be at or greater than our expenses. At that point it would seem there is little we can do to reduce taxes.

[megacorp-firee]

Originally Posted by donheff

When DW and I hit 70, RMDs will be at or greater than our expenses. At that point it would seem there is little we can do to reduce taxes.

yep, Uncle Sam will eventually get his cut ...