ShmoopTube

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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outside of the storage Depot when they're old.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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taxed entirely at the very high ordinary income rates,

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

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

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

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

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

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

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