After-Tax Basis

  

You invested a hundred grand in Amazon two weeks after the IPO cratered. You held it twenty years and now it's worth about a hundred million. You sell it and start shopping for a ninety-million dollar yacht, with a helicopter pad on top.

To your chagrin, the hundred million dollars you thought you were getting because you live in a high-tax blue state...visits the financial version of Jenny Craig in a violent juice cleanse of cash.

You pay 25% long-term gain, 13.3% state tax, 3.8% for residual Obamacare tax, a city and or county tax here and there, and your hundred million dollars of pre-tax dough has quickly turned into sixty-million dollars. Because yes, you've just paid forty-million in taxes. You'll have to look for the economy-sized yacht.

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Finance: What is the Difference Between ...2 Views

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

00:06

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

00:40

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

00:43

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

00:59

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

01:07

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

01:11

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

01:15

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

01:18

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

01:22

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

01:26

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

01:30

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.

01:41

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

01:45

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

01:50

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

01:54

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

01:59

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

02:02

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

02:07

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

02:13

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

02:17

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

02:22

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

02:26

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

02:29

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

02:34

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

02:39

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

02:42

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

02:48

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

02:52

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

02:56

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

03:01

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

03:05

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

03:10

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

03:14

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

03:18

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

03:24

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

03:28

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

03:32

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

03:37

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

03:41

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

03:46

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

03:51

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

03:55

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

03:59

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

04:03

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

04:08

taxed entirely at the very high ordinary income rates,

04:12

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

04:17

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

04:21

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

04:26

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

04:30

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

04:34

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

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