Client is now age 55 and anticipating retirement. Approximately 60% of his total investments are currently held in a tax-exempt account and 40% in a taxable account. Contributions into both accounts are made with after-tax income. In the tax-exempt account, withdrawals are entirely tax-free and without penalty. In the taxable account, client now incurs a 20% tax on both income and realized capital gains. Realized losses can be used to offset current or future income and capital gains.
If client incurred losses in his investment account over past years, would after tax return higher if his investment are held in taxable account, compared to tax exempt account?
If client never had losses in his investment account over past years, would after tax return higher if his investment are held in taxable account, compared to tax exempt account?
For 1st question, it depends. If the losses can totally offset capital gains/income tax, then after tax return should be same in both cases. If we can’t offset the entire income/capital gains tax, then after tax return of taxable should be less than tax exempt account.
For 2nd question, after tax return should be less for taxable account since we can’t offset the capital gains/income tax in future with the losses anymore (Whereas capital gains will not be taxed at all for tax exempt account).
If contributions are on after tax basis to both accounts but withdrawals are not taxed in tax-exempt account and in taxable accounts all kind of gains are taxed, and if client never had losses so there is no tax loss harvesting benefits, then tax exempt account would have higher AT returns. But this is not the case in this example.
Remember this: when your returns are taxable, the government takes part of them when they’re positive, making you worse off (than you would be if they weren’t taxable), but reimburse you for part of them when they’re negative, making you better off (than you would be if they weren’t taxable).
Thank you all for replying. It is very helpful in understanding.
To summarise
If client incurred losses in his investment account over past years, after tax return is higher if his investment are held in taxable account, compared to tax exempt account. Because he gets reimbursement on the investment loss.
If client never had losses in his investment account over past years, after tax return is higher if his investment are held in tax exempt account, compared to taxable account.
If you paid taxes (which happens only if you had a taxable account) - when you make profits on your account - you pay MORE taxes.
If however you had losses - you could say that your account suffered losses - hence your total amount on which tax would be calculated would be reduced by the amount of your losses - and hence you pay LOWER taxes. Government partakes of both the gains as well as losses.
You do not have any such sympathy or effect if you used a tax exempt account. In a tax exempt account you never pay taxes period, and you could lose / gain whatever - you end up just having a balance (with returns on your account).
My 2nd comment: 2) If client never had losses in his investment account over past years, after tax return is higher if his investment are held in tax exempt account, compared to taxable account.
Assume his after tax profit is $10million last year. If he withdraws from tax exempt account, he got $10million. if he withdraws from taxable account with tax rate of 20%, he got 8 million.
The mentioned answers would be correct if he is in fact taking withdrawals.
However, if he is not in the withdrawal stage and the gains / losses on a yearly basis are all unrealized, both the taxable and tax-exempt accounts would be equal, correct?
If the question doesn’t specifically say he realized these losses, are we typically to assume that they are realized and not just paper gains/losses?