Flexible Retirement Planner Support Forum

Jim, I have a couple of questions about the way taxable investments are taxed.

Firstly you say portfolio gains each year are taxed by the specified tax rate (eg 15%). Given that a significant percentage of these gains could be capital gains which would only be taxed when the investment is sold, is the simulator ignoring this and just treating all gains as income? Should we make some adjustment to the tax rate to allow for this?

Secondly, in a year where returns are negative, how does the simulator tax the losses? Does it assume a negative tax (ie deduction of the losses)?

Thanks for a very useful tool.

Regards,

The planner makes the simplification that portfolio returns are taxed at the investment tax rate (default 15%) in the year they occur. Portfolio gains are never taxed at the income tax rate. As you indicate, this is not entirely accurate because a significant portion of the gains will not be realized and taxes can be deferred for long periods on time.

As you indicated in your question, the best way to adjust for this is probably to adjust the tax rate downward to compensate the portfolio for the extra growth that tax deferral should cause.

Another thing I'd suggest, is to reduce the investment tax rate to 0% (from 15%) and run the simulation. That will give you the best case result (investments not taxed) to use as a baseline.


Tax savings from loss harvesting are also ignored. When the portfolio return is negative for a given year, the adjustment to the returns for taxes is skipped.

Theoretically, it wouldn't be that hard to implement a "Percent of returns realized each year" variable along with portfolio basis tracking throughout the simulation. Unfortunately, this is a place where I took a short cut.

A couple people have written about this so you're definitely not alone in your concern. At least the result is a more pessimistic plan than it would be otherwise, rather than a plan that's too rosy.

Best Regards,

Jim

Thanks for the info Jim.

Just one point on the taxation of investments. Wouldn't your method significantly over tax investements?

Because of volaitlity returns are often negative -- they go up and down with a drift upwards at the average rate of return and the higher the volatility the more often an annual return will be negative. Say an investment is 100 and the investment tax rate is 50% (for simplicity). At the end of year one it goes to 120 so tax is 10. Then it drops back to 100. Tax in the loss year would be zero in your system. Then it goes back up to 120. Tax is another 10. So the investment is taxed twice for the same gain. Is my understanding correct?

Given a large percentage of the gain (loss) would be unrealized capital gains (losses) if the percentage of equities was high, then wouldn't it be more accurate to apply the tax rate whether or not there is a gain or a loss in any one year? In a loss year there would be a negative tax. Given unrealized gains are not in real-life taxed until they are realized I would have thought taxing both gains and losses equally would at least allow the user to adjust the investement tax rate in a logical way whereas if gains are potentially being taxed multiple times it would not be easy to calculate the effect of this and hence impossible to adjust the tax rate.

Regards,

The approach I took on taxes was intended to produce more conservative results, but you make a compelling case and I've changed the planner to treat investment taxes more symmetrically as you suggest. I'm always reluctant to make a change that will impact results so much, but I think the case for it is sound.

The change was pretty small and I ran it through the paces on some test cases. Please let me know if it behaves the way you expect.

Regards,

Jim

Thank you for making that change so quickly! I'v had a look at the new one and the results are consistent with the change. I obviously can't easily check it in detail but I ran a test using only the taxable account and the median portfolio balance was significantly higher than the current version using the same inputs.

I appreciate the quick response.

Regards,