Lectures 16-22 Flashcards
capital income tax
taxes on the income you make from your investments (i.e. stocks)
Capital Income Tax System
how is interest taxed? Is this the same when interest is paid by the state and local governments (municipal bonds?)
how are dividends taxed?
interest is taxable at ordinary income tax rate (progressive)
when it’s paid in the form of municipal bonds (by the government), the interest you earn is tax-exempt
dividends are taxed at a lower progressive rate than interest
capital gains
profit for when you sell the asset for a higher price than you bought it
taxes for short-term capital gains vs. long-term capital gains
short term capital gains (ordinary income tax rate)
long term capital gains (dividend tax rate)
what happens if you hold on to your capital gains until you die?
the price of the capital gains is reset and the asset can then be passed on to your heirs
disincentivizes you to sell so you don’t have to pay taxes on it and you can just give it to your heirs
when are capital gains taxed?
when they are REALIZED (when the asset is sold)
vs. dividends are taxed when they are paid
therefore, even though the tax rate for long term capital gains and dividends are the same, it’s advantageous to convert dividends into capital gains
calculating the real interest rate without taxation
real interest rate = nominal interest rate - inflation
after-tax real interest rate
when is capital income taxation much higher?
when inflation is high, the discouraging effect of capital income taxation is much stronger
when inflation is higher, after-tax interest rate is much lower (even negative)
IRA
tax-favored individual retirement accounts
set up by individuals with low contribution amounts
401(k)
managed by private-sector employers
- higher contribution limits
- employers decide employee investment choices
- employers can make matching contributions to the plan
traditional IRA/401(k) vs. Roth IRA/401(k)
traditional: you don’t pay a tax when you put the money into the account, but you have to pay taxes when you take the money out
roth: pay taxes now on contributions, but no taxes later on withdrawals
and in both scenarios, the interest that you earn on the returns throughout the year is not taxed
which is better: Roth or traditional?
if you expect taxes to be higher in the future, do Roth over traditional
if you expect to be richer in the future (and thus expect to pay a higher marginal tax rate), do Roth over traditional
withdrawal rules for a traditional account
withdraw free of penalty after age 59.5
you must start to make withdrawals (required minimum distributions) after 72
if you want to withdraw money before, you pay a penalty
always pay Federal and state income tax on your withdrawals
withdrawal rules for a Roth account
you can always withdraw money without penalty (since you already paid taxes)
withdraw capital income earned in the account free of penalties after 59.5, if you account is at least 5 years odld
changes in asset allocations for 401(k)
less company stock (concentrates risk exposure), less money market funds (too low of a return to finance retirement)
more balanced funds which come in the form of target date funds
balanced funds
both stocks and bonds
target date funds
start out with more equity (stocks) and shift into bonds as your retirement date approaches
target date fund glide path
equity share starts out high and diminishes gradually to some much lower level in retirement
why do people suggest to invest more aggressively when you are young and cut back risks when you get older? (time diversification and human capital argument)
young people have high potential of human capital (future earning power- relatively safe asset)
when young, large implicit investment in safe assets (earning power) so you should compensate by having some extra risk in your financial portfolio (stocks/equities)
as you get older, your future earning power decreases and your financial savings increase
so when you’re older, with a smaller implicit investment in safe assets (less earning power) and larger financial portfolio, cut back financial risk as retirement approaches.
younger people can tolerate more risk (bc they have more time to recover from losses) but less money to invest … since they have a larger time horizon and they are expected to earn more money in the future, the risk of an asset stabilizes over long periods of time so it makes sense to be risker earlier on it life (time diversification)
older people have more money to invest, but less time to recover losses so they should be more conservative
time diversification
risk you take with equity investing is less If you spread the dollar investment out over a period of time rather than concentrating it all in a single period
diversifying the dollars you put in the stock market over time
“half stocks all the time” is safer than “all stocks half the time”
limitations of tdf’s (target date funds)
tdf only adjust equity share to your age, but if you have more savings relative to your income, you should cut back on your equity share
some TDF’s are actively managed, inadequately diversified, and charge inappropriately high fees
insurance manages which risks of life? (PPL)
personal (death, illness, disability)
property (fire, flood, theft)
liability (risks to others for which you are responsible)
property and causality insurance (P & C)
homeowners, renters, auto insurance
moral hazard
the probability or cost of a loss, once you are insured, will go up
(probability) since you know you’re insured, you’re going to be more careless about the way that you behave
(cost)
if you know you’re insured, you let insurance company pay for repair, as opposed to trying to find a cheap repair
lack of inventive to guard against risk when one is protecting from its consequences
deductible
the amount you’re responsible for paying if a loss/repair is needed
incentivizes you to be careful and doesn’t allow you to claim for minor losses
premiums
how much you pay to have insurance
future insurance costs,
if you make a claim, your premium will rise
cost of property and causality insurance depends on
value of property
location of property
risk rating of owner
security devices you install
deductible
coverage limit
coverage limit
the maximum amount of insurance a company will pay
low deductibles: money wasted
summary of article
on average, you can save more money from having a higher deductible than having a lower deductible
people are extremely risk averse and are paying extra (close to $100) in premiums to only be protected an extra $20 bucks
do lower deductibles have higher or lower premiums and why?
low deductibles have HIGHER insurance premiums
- if companies have to process more small claims, operating costs of company increases
- moral hazard: if people are less exposed to losses, more likely to file claims/get into trouble, raising cost of insurance
why do people like low deductibles?
typically for people who lack emergency funds
if you find it difficult to save, this insurance serves as a commitment device when losses occur
but they’re expensive and a better alternative is to combine high-deductible policy with an emergency savings fund
do those who have been insured longer get more sophisticated and change their deductibles from lower to higher?
no!
low deductibles used to be cheaper, but as home values rose, difference in premiums also rose
renewal contracts do not list this new menu?
insurance companies cover ____ losses
unknown losses
preexisting conditions
known losses, won’t be covered by unregulated private insurers
medical history of a serious problem
before 2012, large group poliicies covered preexisting conditions, but individual and small group policies either excluded or charged high prices for coverage
after affordable care act, it was forbidden to exclude or charge more for preexisting conditions
continuation coverage
you’re still given healthcare insurance for 18-36 months if you lose access to a group policy due to job loss, divorce or death from employee
medicare v medicaid
medicare
- for people over 65 (federal)
medicaid
- for lower income people (state-administered)
- think AID, financial AID, poor
two main challenges to u.s heatlh care system
- preexisting conditions
- health care costs (companies try to cut cost by having a select list of providers, having high deductibles etc)
basic v major medical health insurance
hospital, surgical, and physical health expenses
major: anything beyond that
long term care insurance
worth considering if you are over 60 and lack family care options
marginal utility of wealth
high when wealth is low
low when wealth is high
diminishing marginal utility
think ec10 (100 to someone who makes 1,000 is much more than 100 to someone who makes 10,000)
actuarially fair price
the premium rate must equal the probability of an accident
would be possible if losses were idiosyncratic ( uncorrelated across individuals) and insurance company has no sales or operational costs
full coverage
loss has no effect on your marginal utility
full replacement of lost income, full coverage of medical costs,
partial coverage
insures only part of a loss
leaving marginal utility of the loss slightly greater than the marginal utility of the premium (base conditions
why is insurance not actuarially fair?
sales and operating costs
costs of fraud prevention
moral hazard (need to have some exposure to loss so that they can have an incentive to be careful)
adverse selection: makes insurance expensive for all but the riskiest people
adverse selection (in insurance)
people have different loss probabilities, and they know their own loss probability (asymmetric information)
insurance company either does not know loss probability or is prevented by regulation to adjust cost of insurance to reflect that
- i.e. Affordable Care Act- companies couldn’t charge extra for people with preexisting conditions (aka higher loss probabilities)
in adverse selection, who demands more insurance? high-risk people or low risk-people? how does this impact the cost of insurance?
high-risk people demand more insurance than low risk people
Lowers profits (high-risk people are more likely to file claims than low-risk people) which forces companies to drive up the price of their insurance
since the cost is so high, only the highest risk people will choose to buy insurance
death spiral
only the highest risk people will buy insurance
more people are dropping their coverage (particularly healthy people)
