Tax Strategies for High Income Earners Investing in Hedge Funds

Before we juggle terms such as tax credits, taxable income, tax brackets, and tax deductions, you need to understand one thing: U.S. tax law is complicated, even for entities that generally enjoy numerous tax benefits, such as investors. Thus, none of the information you find here should be the sole basis of your tax planning strategy. What you'll find here are some of the most general concepts and strategies that may or may not apply to your tax bill, depending on your personal situation. In fact, by the time you read this, there may be entirely new tax laws in place which change aspects of how high-income earners like yourself pay taxes.

Thus, you should always consult a professional tax adviser before planning your taxes. None of what you'll find here should be construed as tax advice, as CARL doesn't know your personal situation.

In the United States, hedge funds are nearly always set up as limited partnerships. This means that the hedge fund firm or manager is the general partner while you, as an investor, are considered the limited partner in the relationship. Hedge funds are also considered to be flow-through entities (FTEs), sometimes called pass-through entities. That means that any income the fund makes is distributed directly to the limited partners.

This is an important distinction, as it allows hedge funds to avoid double or triple taxation. Double taxation occurs when investors invest money in corporations – the corporation has to pay corporate tax on the money it distributes to its limited partners (dividends). The investor has to pay income tax or rather, capital gains tax on that income again. And by being classified as FTEs, hedge funds avoid having to pay taxes on this money again. You still need to pay, of course, but you can rest assured that the money you gain from your hedge funds won't be taxed multiple times, getting diminished every step of the way.

Short-Term or Long-Term Tax?

As a U.S. investor, your income from a hedge fund investment is taxable income, subject to capital gains tax. However, U.S. tax law also distinguishes between two types of capital gains tax:

• Short-term capital gains tax applies to income derived from assets held for one year or less.
• Long-term capital gains tax applies when an asset is held for more than one year.

As long-term capital gains rates are significantly lower, high-income earners are incentivized to hold assets for a long time. This means investors using a buy-and-hold strategy, private equity investors, or people investing in mutual funds that hold assets for a long time usually benefit from a lower tax bill. Unfortunately, most hedge funds are set up to invest aggressively. They may prefer buying and selling assets within less than a year to generate high income instead of holding onto assets for long periods of time. This means most income derived from hedge funds is likely subject to the higher short-term capital gains tax levels.

Returns from hedge funds often count as short-term capital gains, which is the less favorable of the two taxation methods. Making short-term investments without the help of a hedge fund incurs the same tax, however. The difference is that CARL's quants offer 15%+ targeted returns, with the same tax burden as other investments that may net you significantly lower returns. In other words: Investing with CARL will likely still net you greater returns after tax.

There are a few investment strategies available to high-income earners to limit the amount of tax they need to pay on income derived from hedge funds. Keep in mind, though, that your personal situation may be such that not all of these strategies can work in your favor. Please always consult a professional tax adviser before planning your taxes.

Retirement Deductions

The primary way of limiting the amount of taxes you need to pay on hedge fund income is to limit your adjusted gross income (AGI). This is because the tax you owe is based on your tax bracket, and AGI determines which bracket you fit into. So-called above-the-line tax deductions decrease your AGI, which may make you eligible for a lower tax bracket or further tax benefits.

The most effective above-the-line deductions are contributions to your retirement plan. If you have a traditional Individual Retirement Account (IRA), your contributions to this account are directly deducted from your AGI. Keep in mind that there are limits to how much you can contribute tax-free – as of 2022, the annual maximum is $6,000 or $7,000 if you're 50 years or older. If you have a 401(k) retirement plan, contributions may also be subtracted from your AGI. If you have a Health Savings account, you benefit from tax-free contributions, tax-free growth, and tax-free withdrawals (only for medical expenses, unless you're over 65).

Charitable Donations

Donations to charities don't lower your adjusted gross income, but they can help you maximize the deductions that you can apply to your taxes. This only works if you choose to itemize your deductions – if you take the standard deduction, you won't benefit from donating.

Tax-Deferred Accounts

Some types of investment accounts are tax-deferred, which means you don't pay taxes on the money in your account until you withdraw it. For example, traditional IRAs allow you to put money into your account tax-free (up to the annual limit), and this money can be used to invest and grow your wealth without being taxed. Taxation only occurs when the money is eventually withdrawn.

This strategy doesn't keep your money safe from taxation, but it limits the tax burden you're exposed to annually. For example, you may use the money in your Traditional IRA to invest in CARL's quants, which allows this money to grow tax-free. Only after you withdraw from the account, once you're retired, will the money be subject to taxes. This enables you to engage in tax planning for the future, as you've got all that money sitting in your account for retirement. That way, you know exactly how much of the money will be 'lost' due to taxation once you withdraw it.

Hedge funds in general and CARL's quantitative investment strategies in particular generate significant returns for you, and most hedge fund investments are short term. Thus, you can expect your investment income to fall under the less favorable short-term capital gains taxation model. Since CARL's funds offer 15%+ targeted returns, this still leaves you with a significant amount of money, but it also means that you'll likely want your tax planning done by a professional. CARL suggests contacting a tax adviser to determine the amount of tax you're likely to pay for your planned investment. Keep track of your returns and the amount of money that's readily available to you for further investment or private use.

Once you've defined your tax strategy, contact CARL to set up your account and gain access to some of the most sophisticated quantitative hedge fund strategies on the market today. With 15%+ targeted returns, you'll grow your wealth even if you fall under the short-term capital gains taxation bracket.