How deferring capital gains cuts the tax?
So someone told me that deferred capital gains realisation cuts effective tax rate. I don't really get it - did some google searching but I'm not 100% sure what to look for.
Is there some scheme out there or something? Any links / knowledge greatly appreciated!
Not sure if this is exactly what you're referring. If you defer capital gains realizations until you have capital losses you can lower your effective tax rate by offsetting the gains with losses.
You may want to start by researching "deferred tax liabilities" for a better understanding. Its a complex issue but there is a lot of material out there. Let us know what specifically you dont understand.
Do the math. Say you earn 10% per year one of two ways - first strategy, you buy a stock and hold it for one. Year and get a 10% return, then sell it, pay taxes on gain, and move on. Say tax rate is 30%, so you make 7% per year. Option 2, you buy and hold for X years and then sell at the end and pay 30% tax on gain.
Say we are doing 10 years. What's better, a compounded 7% return or a compounded 10% return and then paying 30% tax on the gain?
that's a lot of hard math
You might as well start practicing, the math used by hedge fund analysts is pretty advanced shit.
@"mk1275" If what you're saying is what people mean when they say "deferred capital gains realization cuts effective tax rate", then it's true...but it also seems kind of dumb. Who buys a security and then, with the intention of re-buying it or some equivalent security, sells it after a year? Presumably one would sell only if he thinks he can get a better return the next year on a different security. Obviously if you think it's going to continue pumping out 10% and that's what you're looking for, you should just hold.
I'm giving a simplified example so that you can see the math. In reality, maybe you hold a stock a year or two and then sell it for whatever reason, deciding to move that money into a different stock. The key rule is that the tax drag on your return is greater the shorter your holding period is.
What this means is, there is a massive advantage in terms of taxation to "buy and hold" type strategies vs active trading strategies. At the extremes, you need to produce a massive amount of alpha to justify a short-term trading strategy, where you are consistently paying short-term capital gains taxes, versus holding a security like Berkshire, where you will have zero tax liability until you sell [no dividends].
Considering the math in the example I gave above; let's say you think Berkshire can return 10% per year, and you are comparing that to an active investing strategy where your portfolio turnover is 1 year [on average, you hold a position for one year]. Let's say you are in NY and your long-term capital gains rate is 31.5%, and ignore the possibility your active strategy would trigger short-term capital gains (taxed at marginal income tax rate, i.e. 40-50%). Over a 20 year investment horizon, your strategy would have to produce a gross return of 12.1% per year just to equal the after-tax return of the Berkshire stock that you just bought and held. Make the investment horizon 30 years, and then you need to do a gross return of 12.7% per year to equal the 10% per year of Berkshire.
The takeaway is that active investors must not only beat passive vehicles in terms of gross returns, they must beat them considerably in order to justify their existence, because taxes favor buy-and-hold style investing and discourage short-term trading.
Thanks for this. Would SB but don't have any!
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