taxable, tax deferred, tax exempt

Reading 10 prac prob 19 Consider a portfolio that is generally appreciating in value. Active trading is most likely to be least attractive in a

a)Taxable account

b)Tax deferred account

c)Tax exempt account

Anwer says that active trading would generate annually taxed income and is most appropriate for a tax-exempt account. If a portfolio contains unrealized losses, a certain aount of trading activity is required to harvest tax losses. Tax efficient management of stocks in taxable accounts does not require passive management. It requires passively allowing gains to grow unharvested, but actively realizing losses. But won’t active trading pay taxes in both taxable account and tax exempt account, so why is the answer a?

Tax exempt accounts do not pay taxes at all, becaus they (and transaction in those accounts) are exempt from taxes.

  1. Active trading in an appreciating portfolio = more taxable income.

  2. Because of compounding, you’d like to keep your profits for as long as possible.

  3. Both Tax Exempt and Deffered will allow you to do that.

  4. The taxable account will NOT. Hence its the least attractive.

Tax Exempt - Taxes are front loaded. You will never pay taxes on any of the gains in this account, short or long term capital gains. You could trade until your’re blue in the face, but you won’t pay any taxes.

Tax Deferred - Taxes are back loaded as you only pay taxes when you withdraw money. The government bears all of the tax risk for tax deferred accounts. They’re saying “We’re not going to tax you on any of this money now so hopefully it grows at 8% per year for 40 years so we can tax a much larger amount in the future”.

Taxable - You can have short and long-term capital gains. Generally short-term gains are taxed as ordinary income so your tax situation can be quite sensitive to the gains generated in a taxable account.

Read up on investment risk as it relates to taxes.