Investors are shifting their portfolio allocations to alternative assets in droves. Traditional assets, or stocks and bonds, fail to provide the returns, diversification, and security investors need in the current market environment. As such, many are turning to investment funds to provide them with the returns they desire.
But what many investors don’t know is that there are tax advantages to investing in these funds. Chiefly, the illiquid nature of private market funds means that investors will benefit from long-term capital gains tax rates far lower than ordinary income tax rates.
Carried interest is taxed as capital gains
Carried interest, which has a history dating back to the Renaissance, is the portion of future profits that investment fund managers receive from the investments they manage. Typically, fund managers charge investors a management fee, often 2% of the assets, and retain 20% of future profits generated by their investments.
The IRS permits the taxation of carried interest as capital gains, resulting in a significant financial benefit for the private equity and venture capital industry. The federal long-term capital gains tax rate is 20%, whereas the top federal income tax rate is 37%.
This difference in tax rates incentivizes investors to allocate their portfolios to investment funds that can take advantage of the favorable tax treatment of carried interest as capital gains.
Low long-term tax rates
In the US, long-term capital gains are taxed at one of three rates: 0%, 15%, or 20%. Capital gains taxes are only applied to gains above the investor’s cost basis.
If you’re single and earn less than $41,675, you are eligible for the 0% capital gains tax rate. Investors who earn between $41,675 and $459,750 are subject to the 15% rate, and those earning more than $459,750 are subject to the 20% rate.
The tax brackets look slightly different on the income side but are much more severe. Single taxpayers who earned over $539,900 will have to pay $162,718 plus 37% of the excess over $539,900.
Income tax applies to any capital gain realized on a security that was held for less than one year. For instance, if you were day trading stocks on Robinhood, you would be subject to the ordinary income tax rate. Tax rates on collectibles, like art or wine, are much steeper than long-term holdings on private equity or venture capital, with a max 28% tax rate.
Additional benefits with retirement accounts
Investing in private market funds through retirement accounts, such as a 401(k) or IRA, offers additional tax advantages. The funds in these accounts grow tax-deferred, meaning investors won’t have to pay taxes on investment gains until the money is withdrawn during retirement.
Institutional investors, such as endowments and family offices, have long recognized the tax benefits of alternative assets in their portfolios. By adopting a long-term view of investing, they have outperformed traditional benchmarks for decades.
Private market investments often come with a lock-up period of up to ten to twelve years, aligning well with the illiquid nature of retirement funds.
Simply put, investment funds offer meaningful tax advantages, alongside attractive risk-adjusted returns. With the built-in ability to take advantage of long-term capital gains tax rates, investors can increase their returns and create generational wealth.