Types of Hedge Fund Investors

TABLE 3.1
Benefit of Postponing Tax Payments on Hedge Fund Returns

Year	Non-IRA	IRA	Tax If Withdrawn	Ner Balance
1	$66.97	$110.00	$40.70	$ 69.30
2	$71.19	$121.00	$44.77	$ 76.23
3	$75.67	$133.10	$49.25	$ 83.85
4	$80.44	$146.41	$54.17	$ 92.24
5	$85.51	$161.05	$59.59	$101.46

Table 3.1 shows the benefit of postponing tax payments on hedge fund
returns. If a taxpayer pays 37 percent marginal income tax, a $100 return
would require a tax payment of $37 in the current tax year. In the table,
the after-tax income is reinvested in the hedge fund, earning 10 percent but
paying tax at 37 percent each year. The income with the reinvested return
grows to $85.51 over five years after all taxes have been paid.
Alternatively, suppose that the tax on the $100 of income is postponed
one or more years because it resides in a tax-deferred account, such as an
IRA. The table shows the value of $100 of taxable income growing annu-
ally at 10 percent, as previously. If the money is withdrawn after one year,
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the investor must pay $40.70 in income tax (37 percent of $110) but
would have $69.30 available after paying income taxes. The value of the
deferral rises each year, so that by the fifth year, the $100 of taxable in-
come could represent $101.46 in funds to the hedge fund investor if rein-
vested in an IRA but only $85.51 without the benefit of deferral. The value
of deferral on this $100 of hedge fund income continues to rise each year
the investment is held in a tax-deferred retirement account. In addition, the
hedge fund produces additional income each year that also benefits from
this deferral.
Traditional IRA
The traditional or contributory IRA is the best known of a
growing list of tax-deferred retirement savings accounts. Contributions to
the fund are subtracted from taxable income. For example, suppose an in-
vestor made a $3,000 contribution to an IRA in 2003 (the maximum per-
mitted for taxpayers with income of $95,000 or less--the permitted
investment scales down to $0 for incomes above $110,000). If the investor
pays a 28 percent tax (the marginal tax rate for a single taxpayer in 2003
for incomes between $68,800 and $143,500
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), the tax liability is lower by
$1,050 ($3,000
x 35) so the net cash flow is $1,950 to establish a $3,000
balance in the IRA. Any money (either the original principal or return on
the investment) withdrawn from the IRA is taxed as ordinary income.
Types of Hedge Fund Investors
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