Tax Drag

finance a la shmoop. what's the difference between taxable and untaxable

investment returns? for starters a return refers to getting more than $1

back after you've invested that dollar. sure you can invest a dollar and get a

negative return but well nobody goes into an investment hoping to lose money. [return explained in a graphic]

other than the you know geniuses in Congress. the ultimate untaxed return is

the IRA or the 401k pension system and it's not really untaxed, it's more like a

delayed tax, because you pay the money when you take it out and that system

investors sock away modest amounts of money each year for decades not having

to pay taxes on them until after they're about 70 years old and then they

gradually withdraw money from their pension funds spending it on golf third

marriages and dentures but key note here an IRA is not untaxed it simply deferred

tax meaning that as you withdraw money from your pension you are then taxed at

your ordinary income rate. but people like doing this because we have a [income tax rate in a graphic]

progressive tax system where from like zero to ten grand the tax is almost

nothing, from ten grand to thirty grand it's low, and like over half a million

it's like really high. got it? it's progressive in quotes. there as we can

ruefully say. and yeah the IRS doesn't let you get away with anything they'll

eventually tax pretty much everything you've got that said the pension and

retirement system is a really big benefit for most Americans who are

either undisciplined about saving money for their old age or clueless about how

the system works and government you know holding their hand sometimes squeezing

it so hard it hurts helps them to not have to live in a station wagon parked [uncle sam holds hands with citizen]

outside of the storage Depot when they're old.

so those returns are taxed eventually but figuring out how good or bad your

return is revolves largely around when you decided to pay the tax. presumably in

your old age you'll earn less money than you earned when you were working that

full-time job so that tax rate will likely be a lot less when you're 75 than

it was when you were 45. all right at the other end of the wealth spectrum you

have hedge funds all right so those are an example of generally untaxed

or delayed tax investment returns. you only pay the tax way at the very end so

you don't really worry too much if you trade stocks and realize gains and have

high churn mutual funds inside of your IRA as long as it performs well at the [money in bundles]

end of your working career you'll have a bunch of dough to go spend on golf

dentures and third wives all that stuff. okay they have beautiful offices fancy

jets they cater to the wealthy people on the planet and the numbers can be very

deceiving, because every gain on a hedge fund is taxed and most people don't have

hedge funds in their IRAs. got it all right, well here's a scenario a

soon-to-be retired proctologist who's at the rear end of his career invests in a

hedge fund and this is not inside of his IRA this is just his personal investing

in the hedge fund. the manager claims he's up 50 percent this year and the

proctologist is licking his chops thinking his million box is now worth

1.5 million, but oh that is so not the case. [man thinks about the math of returns rates]

instead the hedge fund charged a fee of 2% for managing the money so take that

50% game down to 48 percent and in fairness many hedge funds quote a net

number but we're just giving you something gross here to chew on. the

hedge fund also took a 20% success fee or profit participation fee or carry,

such that the investor paid another nine point six percent in fees which then get

subtracted off the top. so we did the math there nine point six twenty percent

of that forty eight the investor now has a pre-tax return of about 38 percent in

change. still not bad but an up fifty percent year for a hedge fund is like a

top five percent all-time kind of return. if they were in fact edged meaning most

hedge funds give up much of their gains by protecting themselves in case of bomb

hits in the middle east and the market goes down a lot. that's hedged. right but

some hedge funds don't really hedge themselves and so they can have big

numbers. all right so now comes the taxes hedge funds generally realize gains [man raises hands on trading floor]

entirely in the year in which they profit. that is the 38 percent gain is

taxed entirely at the very high ordinary income rates,

so the hedge fund itself after-tax for a 50% tax bracket payer is really only

returning 19% to the investor after-tax not 50.

yikes what seemed like the monster year was really a good year .so

let's just hope our proctologist pal didn't start spending all that money he

thought he had no but really didn't, so what we got a feeling he's gonna have to

start from the bottom once again. [doctor frowns as he drives car down the road]