Tax question

A client has $100 in a taxable account and $100 in a Tax Deferred Account. Both accounts incurred losses at the end of the year. Tax harvesting is available. Had the investor placed more money in the taxable account from the beginning, would the volatility of the returns had increased or decreased? Also, would the after tax returns be higher or lower?

volatility decreases, return increases.

^That would have been the correct one i think. I put down the wrong choice though

What about the deferred tax asset?

Volatility decreases and return decreases bcs you pay taxes.

But you have losses


Exactly. I dont remember anything about taxable income. Both accounts had losses. In that case, what would be the difference in taxes at the end of the year? Wouldn’t the after tax return be the same?

my answer is return is the same but investment risk reduces …government shares investment risk.

You would have to assume that loss carry forwards are considered investment gain and that any income generated was less than the realized losses. I felt the same way but ultimately, I think it’s too much of a stretch to operate under those assumptions. I don’t think you’re wrong, Hank. But I don’t think that answer is going to fly

I believe in the Schweser notes one of the instructors said not to make assumptions. Answer questions with a “holding all other factors constant mentality”. If the rule is taxable accts increase tax drag and reduce Std Dev by (1-tax) you should answer questions as such.

^I dont get what you mean by that.

Honestly, I’m not sure that I’m right. I just think that I’m better off not making assumptions like the above. Even though I thought the same thing.

I think you did right.

increase/decrease here, wish I could state reasons but cant due to obvious reasons

Can you not use the capital losses to offset the income gains? Or is it soley capital gains that can have losses applied to them?

Can you not use the capital losses to offset the income gains? Or is it soley capital gains that can have losses applied to them?

Return increases and volatility down

with taxable account gov’t shares part of the risk

^I did what Zerobonus did, but after the exam, I rethought the question and realized there weren’t any gains.

when government\s share of taxes lowers portfolio’s volatility, it lowers both losses and gains.

in this case, portfolio had loss, so the loss is lowered in taxable account.

A lower loss = higher return

-5% return is higher than -10% return, no?

The original poster forgot to mention that the question was about ‘that year’.

Now, if both accounts were 100 at the beginning and lost 20%, ending value is 80. Neither pay taxes and since we are interested in ‘that year’ only (not future tax harvesting benefits), the return was equal -20% for both.

I believe the same should apply to volatility ‘that year’. If your accounts go down 20%, they go down 20% and have thus the same volatility. Of course one could invent assumptions on what would have happened if we had measured volatility based on monthly values during ‘that year’. In that case, one month’s loss would have decreased tax liability the next month and sigma(1-t) would have applied. But now we only had one year and one observation.

Someone should email them and challenge this question