I’m a bit confused with the answer in this CFA question from 2012. It talks about a football coach who has 60% o investments a tax-exempt account and 40% taxable account. Contributions into both accounts made with after-tax income. Tax-exempt account, withdrawals are entirely tax-free and without penalty. In taxable account, he pays 20% tax on both income and realized capital gains. Realized losses can be used to offset current or future income and capital gains. He experiences losses in both of his investment accounts over the past year. Advisor suggests that over the last year, both Alonso’s after-tax return would have been higher if a larger proportion of assets had been held in the taxable account.
Apparently this statement is correct, with explanation given that he can can use losses to offset other income or realized gains in the taxable account. I understand this point, but would think that the optimum situation in the taxable account i.e. paying net taxes of zero by offsetting all investment income/ gains against losses, would equal the return in a tax exempt account - any thus net income/gain would leave him worse off?
Is there an opportunity to offset the losses against the previous 20% of tax paid BEFORE investment into the taxable account, (rather than the investment income from the taxable account) and that’s why the return is higher than tax exempt account? I’m not sure that’s what CFA are referring to. Thanks for help in advance
Let’s say both accounts lose 10% and the losses were recognized. The tax exempt account has no tax implications and therefore the loss is 10% or 6% weighted (10% x 60% allocation).
The taxable account has a tax shield 10% * (1-20%) = 8% after tax loss. x 40% = 3.2% weighted loss.
Total portfolio loss is 6% + 3.2% = 9.2%, if he was 100% allocated to the taxable account his loss would have been 8%.
thanks PiratesSay, but I don’t understand where the taxable account get its 20% tax shield from- is this a) the original tax deduction before the post tax contribution was put into a taxable account or b)other investment income/gains in the taxable account (because it doesn’t seem like there are any to use against the losses). If its a), the question says realised losses can be offset against current/future income/gains ie. not past income…
No there is no tax deduction in both accounts the amounts being put into the account is AFTER TAX - meaning there is no deduction.
The 20% will apply to future income/gains - thus future gains are shielded - the NON-taxable account does not offer this because all income and gains are not taxable and therefore losses are not deductible.
It’s a bit of a poorly framed question but you are also over thinking it. In taxable accounts you get the tax shield on losses so your return will be higher than if the portfolio was tax exempt - however, the opposite is true when there are gains.
I’m still not with you completely Piratessay! Maybe I am over thinking it, but do you assume there is gain/income in the current period for the tax shield benefit to be used against in the taxable account, or are you assuming the tax shield benefit in the current period is used against future income…thanks again for your replies (Schweser doesn’t seem v good on this topic!)
Lets say you invested $200 total in Taxable account which in turn is split equally between Stock A and Stock B, by end of the year Stock A is at $150 and Stock B is at $80. If you don’t have tax shield you will be paying 20%on $50 capital gains which would be $10, but in this case you do netting $50 gains - $20 loss on stock B so total gains = $30, tax would be 20%*30 = 6, tax savings because of tax shield is $4. Tax-exempt accounts are profitable when you don’t have any losses in portfolio. Hope this helps.
thank you, vallabhu. Where i am struggling is understanding what income or gains the 20% is sheltering - are you assuming he has sufifcient gains/income within his taxable account that has experienced losses or are you assuming tax benefit will be brought forward against future income/gains. If there are no gains/income in the current period, then there is no tax sheltering benefit in the current period - right? Thanks again!
There may be a benefit in the current period regardless of gains. In the U.S., for example, you are able to deduct up to $3k of losses without any offsetting gains.
OK, thanks you PiratesSay - I’ve got the principle but as you say probably not worded very well.