Next, Quinn discusses taxation of investments with the Martins. Their interest income is taxed at 35%, and capital gains and dividends are taxed at 20%. The Martins want to minimize taxes. Based on personal research, Neal makes the following two statements:
Statement 1The after-tax return volatility of assets held in taxable accounts will be less than the pre-tax return volatility.
Statement 2Assets that receive more favorable tax treatment should be held in tax-deferred accounts.
Q. Which of Neal’s statements regarding the taxation of investments is correct?
- Statement 1 only
- Statement 2 only
- Both Statement 1 and Statement 2
Solution
A is correct. Taxes alter the distribution of returns by both reducing the expected mean return and muting the dispersion of returns. The portion of an owner’s taxable assets that are eligible for lower tax rates and deferred capital gains tax treatment should first be allocated to the investor’s taxable accounts.