CFA 2018 r09 taxes and private wealth management in a global context slides

Level III Taxes and Private Wealth Management in a Global Context www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Introduction Overview of Global Income Tax Structures After-Tax Accumulations and Returns For Taxable Accounts Types of Investment Accounts Taxes and Investment Risk Implications for Wealth Management www.ift.world Introduction • Learn basic concepts which serve as foundation for building tax-aware investment models • Develop framework with which advisers can communicate impact of taxes on portfolio returns www.ift.world Overview of Global Income Tax Structure Taxes on Income Wealth-Based Taxes Taxes on Consumption 2.1 International Comparisons of Income Taxation 2.2 Common Elements 2.3 General Income Tax Regimes 2.4 Other Considerations www.ift.world Example Progressive Tax Rate Structure Ordinary income Investment income often taxed differently based on the nature of the income: Interest, dividends, capital gains Common Progressive Regime Heavy Dividend Tax Regime Heavy Capital Gain Tax Regime Heavy Interest Tax Regime Light Capital Gain Tax Regime Flat and Light Regime Flat and Heavy Regime www.ift.world After-Tax Accumulations and Returns for Taxable Accounts Returns-Based Taxes: Accrual Taxes on Interest and Dividends www.ift.world Example Flat Tax Rate = 20% 7% return over 20 years Initial portfolio 100,000 Expected wealth after 20 years? What portion of investment gains consumed by taxes? www.ift.world Returns-Based Taxes: Deferred Capital Gains www.ift.world Example Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years What is the expected wealth at the end of 20 years? What portion of investment gain consumed by taxes? www.ift.world Cost Basis www.ift.world 10 Future Long Term Accumulation In the previous example we did not consider of deferred capital gains taxes If we do, the effective capital gains tax rate is: Future after-tax accumulation: www.ift.world 15 Example 8: Future Long Term Accumulation Portfolio = 100,000 8% gain 5-year horizon Interest = 400, Dividend = 2,000 CG = 3,600 Dividend and realized capital gains taxed at 15% Interest taxed at 35% Look at Exhibit www.ift.world 16 3.3 Accrual Equivalent Returns and Tax Rates Accrual equivalent after-tax return is the tax-free return that if accrued annually produces the same after-tax accumulation as the taxable portfolio Say 100  121 in years after taxes Accrual equivalent return is 10% Embedded example: 100  138.66 in years after taxes What is accrual equivalent return? Accrual Equivalent Tax Rates www.ift.world 17 Example Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years What is the accrual equivalent return? What is the accrual equivalent tax rate? www.ift.world 18 Types of Investment Accounts Taxable Accounts Invest after-tax money Profits/returns are taxed (as discussed in section 3) Tax Deferred Accounts (TDA) IRA Tax Exempt Accounts Roth IRA www.ift.world 19 Example 10 100,000 for 20 years 7% return Tax = 20% Compute after-tax wealth after 20 years: Taxable account, taxed annually Taxable account Deferred capital gains tax Tax deferred account Tax exempt account www.ift.world 20 4.3 After-Tax Asset Allocation Stocks worth 1.5 million in TDA Bonds worth 0.5 million in TEA What are weights? Need to consider after tax weights www.ift.world 21 4.4 Choosing Among Account Types TDE seems better than TDA but… Contributions to TDA are tax deductible Investors tax rate might be lower upon withdrawal Example 11 www.ift.world 22 Taxes and Investment Risk For assets in taxable accounts: Taxing authority shares investment risk with investor Hence, taxes can reduce investment risk See Exhibit if you want to be super diligent For assets in TDAs and TEAs: Investor bears all risk associated with returns www.ift.world 23 Implications for Wealth Management Techniques for effectively managing tax liabilities  Tax Alpha 6.1 Asset Location 6.2 Trading Behavior 6.3 Tax Loss Harvesting 6.4 Holding Period Management 6.5 After-Tax Mean-Variance Optimization www.ift.world 24 6.1 Asset Location Three types of accounts: 1) Taxable 2) TDA and 3) Tax Exempt Choice of where to place specific assets is called the asset location decision TDAs and Tax-Exempt Accounts Taxable Accounts Securities which would otherwise be heavily taxed Lightly taxed securities www.ift.world 25 6.2 Trading Behavior If tax on short term gains > tax on long term gains  Reduce short-term trading Active managers must earn greater pre-tax alphas than passive managers to offset tax drag of active trading www.ift.world 26 6.3 Tax Loss Harvesting Realize loss to offset gain  Tax Loss Harvesting Example 12 Current Tax Saving Tax saving realized in a given year from tax loss harvesting overstates the true gain Selling security at a loss resets costs basis (B) to a lower level  higher future tax liability Example 13 Recognizing already incurred loss for tax purposes increases after-tax money available for investments Example 14 Highest In First Out (HIFO) www.ift.world 27 6.4 Holding Period Management Many tax regimes encourage longer term investments Example 15 6.5 After-Tax Mean-Variance Optimization Traditional mean-variance optimization can be modified to accommodate after-tax risk and return Evaluate based on accrual equivalent returns Consider optimal asset location www.ift.world 28 Review learning objectives Examples Practice Problems www.ift.world 29 ... Regime Flat and Heavy Regime www.ift.world After-Tax Accumulations and Returns for Taxable Accounts Returns-Based Taxes: Accrual Taxes on Interest and Dividends www.ift.world Example Flat Tax Rate... Tax Rates Accrual equivalent after-tax return is the tax-free return that if accrued annually produces the same after-tax accumulation as the taxable portfolio Say 100  121 in years after taxes. .. return Tax = 20% Compute after-tax wealth after 20 years: Taxable account, taxed annually Taxable account Deferred capital gains tax Tax deferred account Tax exempt account www.ift.world 20 4.3 After-Tax