Juan Pablo Alonso is now age 54 and anticipating retirement. Approximately 60% of his total
investments are currently held in a tax-exempt account and 40% in a taxable account.
Contributions into both accounts are made with after-tax income. In the tax-exempt account,
withdrawals are entirely tax-free and without penalty. In the taxable account, Alonso now incurs
a 20% tax on both income and realized capital gains. Realized losses can be used to offset
current or future income and capital gains.
Alonso experienced substantial losses in both of his investment accounts over the past year. He
estimates that he will need to postpone retirement and questions whether his investments were
structured optimally. Alonso meets with his advisor to discuss the effects of the tax regime on his
portfolios. The advisor suggests that over the last year, both Alonso’s after-tax return and
investment risk would have been higher if a larger proportion of assets had been held in the
A. Determine, based only on tax considerations, whether Alonso’s advisor is correct or
incorrect with respect to Alonso’s:
i. after-tax return.
ii. investment risk
Answer given :
Alonso’s after-tax return would have been greater than or
equal to his actual return, all else equal, if a greater proportion
of his investments had been in taxable accounts. This is
because he can use losses to offset other income or realized
I ll explain with an example lets assume total amount is 1000. Tax Exempt – 600 & taxed – 400.
1. loss available for offset<400
2. loss available for offset=400
3. loss available for offset>400
1. The loss will be offset completely & on the remaining amount (i.e. 400 – loss) the tax rate of 20% shall be applied. So for case 1 increasing weight to taxed accounts will reduce return as more tax has to be paid on the increased weights.
2. Similar to case 1.
3. The total to be taxed amount of 400 will be offset by the loss of 400. Now increasing weightage to taxed accounts will help offsetting the loss with the gain. But what is the point in moving the gains from an already not taxed account to taxed account to offset the loss? There surely cannot be an increase in return.
Please correct me if I am wrong!
@Ashwin – while your example is fine, the answer is still right as you cannot look at wealth planning at one point in time only, it looks at the future too. And just because realized losses can’t be used today, but it can used to offset future income and capital gains still. Same thing you’d done if it is your situation. You just carryforward those losses for future offsets, and by definition your future return would be improved vs. status quo.
I totally agree that the losses can be used to offset future gains.. but even then for the next year the same 3 cases apply. I wud hve agreed with u if it was moved from a tax deferred or a taxed account to this but in our case the weightage of tax exempt accounts ll be reduced to over weight the taxed accounts. So this ll not increase the return ?? or am i missing something very silly in between?
I ll explain with an example lets assume…
Please correct me if I am wrong!
I had trouble following the example, so I’ll just try to explain with an example of my own:
Look at the extremes…
If your entire portfolio was in a tax-exempt account, and your investments decline by 20%, your after tax loss is 20%.
If your entire portfolio was in a taxable account, and your investments decline by 20%, your return is HIGHER (potentially) than -20%, because you can reduce the taxes you pay using your losses. Assume a 25% tax rate: -20(1-.25)= -20(.75) = 15%.
So, if a larger portion had been in the taxable account, a larger portion would have been subject to the tax “benefit,” increasing return.
NOTE: This situation would be opposite for a portfolio that experiences gains during the year.
(Now someone can please correct me if I’m wrong)
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