CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r09 taxes and private weath management in a global context IFT notes

Taxes and Private Wealth Management in a Global Context IFT Notes Taxes and Private Wealth Management in a Global Context Introduction Overview of Global Income Tax Structures 2.1 International Comparisons of Income Taxation 2.2 Common Elements 2.3 General Income Tax Regimes 2.4 Other Considerations After-Tax Accumulations and Returns for Taxable Accounts 3.1 Simple Tax Environments 3.2 Blended Taxing Environments 3.3 Accrual Equivalent Returns and Tax Rates 10 Types of Investment Accounts 10 4.1 Tax-Deferred Accounts 11 4.2 Tax-Exempt Accounts 11 4.3 After-Tax Asset Allocation 11 4.4 Choosing Among Account Types 11 Taxes and Investment Risk 12 Implications for Wealth Management 12 6.1 Asset Location 12 6.2 Trading Behavior 12 6.3 Tax Loss Harvesting 13 6.4 Holding Period Management 13 6.5 After-Tax Mean-Variance Optimization 14 Summary 14 Examples from the Curriculum 17 Example Tax Rates 17 Example Accrual Taxes 18 Example Deferred Capital Gains 19 Example Cost Basis 19 Example Wealth Tax 20 Example Blended Tax Environment 20 Example Blended Tax Environment: After Tax Return 21 Example Blended Tax Environment: Future Long Term Accumulation 22 Example Accrual Equivalent Return 23 Example 10 Comparing Accumulations of Account Types 23 Example 11 Choosing Among Account Types 24 Example 12 Tax Loss Harvesting: Current Tax Savings 25 Example 13 Tax Loss Harvesting: Tax Deferral 26 Example 14 Tax Loss Harvesting: Adding Net-of-Tax Principal 27 Example 15 Long-Term Gain 28 IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes Introduction The topic of taxes is complicated and tax laws vary from country to country In this reading we will address some of the more common and basic concepts of taxation This will help us learn the fundamental building blocks that are needed to evaluate taxes and calculate after-tax investment returns This reading will also help us develop a framework with which advisors can communicate the impact of taxes on portfolio returns Overview of Global Income Tax Structures Broadly speaking, there are three kinds of taxes: Taxes on income Wealth-based taxes Taxes on consumption Taxes on Income For exam purposes, the most important taxes are taxes on income The word “income” is most commonly associated with an individual’s employment (e.g., salaries and wages) However, taxes on employment income (also known as “ordinary income”) are typically addressed in the context of an investor’s Investment Policy Statement (IPS), which is the subject of Managing Individual Investor Portfolios This reading is primarily concerned with investment income, of which there are three sources: Interest Income Dividend Income Capital Gains There are two further categories of capital gains: Unrealized – the amount an investment appreciates above its purchase price before it is sold Realized – the difference between an investment’s sale price and its purchase price It is therefore more accurate to say that there are four sources of investment income: 3a 3b Interest Income Dividend Income Capital Gains (Unrealized) Capital Gains (Realized) As will be discussed in the next section, the distinction between unrealized and realized capital gains is particularly important from a tax perspective Wealth-based Taxes Wealth-based taxes come in two forms: Taxes on transferring wealth IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes Taxes on holding wealth An investor who wishes to transfer wealth can so either as gift during his lifetime, or after his death Therefore, the two major forms of wealth transfer taxes are gift taxes and estate taxes These will be covered in section 4.1 of Estate Planning in a Global Context This reading, specifically section 3.1.4, is concerned with taxes on holding wealth, such as property taxes on real estate Taxes on Consumption Consumption taxes, such as sales taxes or value added taxes (VAT) are paid when people purchase goods or services The focus of this reading is on taxes on investment income and wealth-bases taxes 2.1 International Comparisons of Income Taxation Sections 2.1 to 2.3 report findings from a survey of tax laws in over 50 countries around the world 2.2 Common Elements Progressive tax systems apply increasingly higher marginal tax rates to higher levels of income In Example 1, Vanessa Wong lives in a jurisdiction that applies the following marginal tax rates:     20% on the first €30,000 of taxable income 30% on income above €30,000, up to €60,000 40% on income above €60,000, up to €90,000 50% on income above €90,000 Refer to Example from the curriculum The alternative to a progressive tax system is to apply a single, flat tax rate to all levels of income In the real world, progressive tax systems are far more common than flat tax systems Investment income is often taxed differently based on the nature of the income – interest, dividends, capital gains It is possible that a country may have different tax rates for each of these sources of investment income 2.3 General Income Tax Regimes This section addresses LO.a: LO.a: Compare basic global taxation regimes as they relate to the taxation of dividend income, interest income, realized capital gains, and unrealized capital gains Tax regimes can be classified into the following seven categories: IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context Tax Regime 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 Tax system for ordinary income Progressive Progressive Progressive Progressive Progressive Flat Flat Favorable treatment for interest? Yes Yes Yes No No Yes Yes Favorable treatment for dividends? Yes No Yes Yes No Yes No IFT Notes Favourable treatment for capital gains? Yes Yes No Yes Yes Yes No 2.4 Other Considerations This section introduces the impact of tax-deferred savings accounts and wealth taxes This will be covered in detail in later sections After-Tax Accumulations and Returns for Taxable Accounts This section addresses the following: LO.b: Determine the effects of different types of taxes and tax regimes on future wealth accumulation LO.c: Explain how investment return and investment horizon affect the tax impact associated with an investment 3.1 Simple Tax Environments The examples discussed in this reading assume that income is taxed at a single flat rate, rather than at a series of progressive rates This simplifying assumption is made, in part, because it is very complicated to design models that accommodate multiple tax brackets 3.1.1 Returns-Based Taxes: Accrual Taxes on Interest and Dividends The future value of an investment can be determined by multiplying the original investment by a future value interest factor (FVIF) If an investment’s returns are taxed annually, as is often the case for when returns are received in the form of interest or dividend income, its future value interest factor (FVIF i) calculated as follows: FVIFi = [1 + r(1 − t i )]n To understand the formula above, consider the following two scenarios from the curriculum In Scenario 1, an investment of €100 is made today and returns are allowed to compound tax-free In Scenario 2, the returns on the same €100 investment made today are subject to a 30% annual accrual tax Scenario IFT Notes for the Level III Exam Scenario www.ift.world Page Taxes and Private Wealth Management in a Global Context Original investment Holding period (n) Pre-tax rate of return (r) Tax rate on annual returns (ti) FVIFi Future value of investment Gain on investment €100 10 years 6% n/a [1 + 0.06(1 – 0.00)]10 = 1.7908 €100 x 1.7908 = €179.08 €179.08 - €100 = €79.08 IFT Notes €100 10 years 6% 30% [1 + 0.06(1 – 0.30)]10 = 1.5090 €100 x 1.5090 = €150.90 €150.90 - €100 = €50.90 The €50.90 gain in Scenario is €28.18 less than the €79.08 gain in Scenario Put differently, €28.18 of a potential €79.08 gain was lost due to taxes This loss of potential gains is called “tax drag” and is expressed as a percentage of the gain that would have been realized if the investment had been allowed to grow tax-free In the example above, the tax drag is 35.6 percent (€28.18/€79.08) Tax Drag relationships Exhibit shows the effect of taxes on capital growth for across different investment horizons and rates of return r (%) 10 12 14 16 18 0.308 0.317 0.325 0.333 0.341 0.348 0.356 0.364 0.371 Investment Horizon in Years (n) 10 15 20 25 30 0.319 0.330 0.340 0.351 0.362 0.338 0.359 0.381 0.403 0.425 0.356 0.389 0.421 0.454 0.486 0.375 0.418 0.461 0.503 0.545 0.393 0.446 0.499 0.550 0.598 0.411 0.474 0.535 0.593 0.646 0.429 0.501 0.569 0.633 0.689 0.446 0.526 0.601 0.669 0.727 0.462 0.551 0.631 0.701 0.760 35 0.373 0.447 0.518 0.584 0.643 0.694 0.739 0.776 0.808 40 0.384 0.469 0.549 0.622 0.684 0.737 0.781 0.818 0.848 The data in Exhibit allows us to draw four conclusions: The tax drag of annual accrual taxes will always be greater than the nominal tax rate As investment horizon increases the tax drag increases As investment returns increases the tax drag increases Return and investment horizon have a multiplicative effect on the tax drag Refer to Example from the curriculum 3.1.2 Returns-Based Taxes: Deferred Capital Gains In section 3.1.1, we considered the effect of taxing returns annually, as is typically done for investment that provide income in the form of interest or dividends In this section, we consider the effect of taxing capital gains, which can be either realized or unrealized IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes Imagine that an investor paid €20 last year for a stock that is currently trading at €100 If the investor sells that stock today, she will have realized a capital gain of €80 (€100 sale price - €20 purchase price) If she continues to hold the stock (i.e., does not sell it), she will still have a €80 capital gain, but it will remain unrealized As noted in the curriculum, “it is very rare for unrealized capital gains to be taxed.” The future value interest factor for an investment that remains untaxed until capital gains are realized (FVIFcg) is calculated using either of the formulas below: FVIFcg = (1 + r)n − [(1 + r)n − 1)]t cg Which can be further simplified to: FVIFcg = (1 + r)n (1 − t cg ) + t cg Note that both of these formulas yield identical results Recall that in Scenario in the previous section, a €100 investment grew to a value to €179.08 if its percent annual returns were allowed to compound tax-free The €100 investment in Scenario grew to a value of €150.90 if the same percent annual returns were taxed at a rate of 30 percent In Scenario 3, we consider the impact of a 30 percent tax on deferred capital gains (tcg) Original investment Holding period (n) Pre-tax rate of return (r) Tax rate on deferred capital gains (tcg) FVIFcg Future value of investment Gain on investment Scenario €100 10 years 6% 30% (1 + 0.06) 10 (1 – 0.30) + 0.30 = 1.5536 €100 x 1.5536 = €155.36 €155.36 - €100 = €55.36 The €55.36 gain in Scenario is €23.72 less than the €79.08 gain in Scenario This tax drag in this case is exactly 30 percent (€23.72/€79.08), which is identical to the nominal tax rate on deferred capital gains Tax Drag relationships Compared to the three relationships we saw for accrual taxes, the relationships for deferred capital gains taxes are quite different: Tax drag percentage is equal to the nominal tax rate As the investment horizon increases the tax drag is unchanged As the investment return increases the tax drag is unchanged In addition, when taxes are deferred: As investment horizon increases, the value of the tax deferral increases IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes As investment return increases, the value of the tax deferral increases Refer to Example from the curriculum 3.1.3 Cost Basis Cost basis is an investment’s original purchase price The future value interest factor of an investment with a cost basis below current market value (FVIFcgb) is calculated using either of the formulas below: FVIFcgb = (1 + r)n (1 − t cg ) + t cg − (1 − B)t cg FVIFcgb = (1 + r)n (1 − t cg ) + t cg B Note that the term B represents the ratio of the purchase price (i.e., cost basis) to the current market price If the same investment from Scenarios 1, 2, and that has a current market value of €100 was originally purchased for €80, its future value could be calculated as follows: Original investment Current market price Unrealized capital gain Cost basis (B) Holding period (n) Pre-tax rate of return (r) Tax rate on deferred capital gains (tcg) FVIFcgb Future value of investment Scenario €80 €100 €100 - €80 = €20 €80/€100 = 0.8 10 years 6% 30% (1 + 0.06) 10 (1 – 0.30) + (0.30)(0.8) = 1.4936 €100 x 1.4936 = €149.36 As shown in the table below, the after-tax future value of the investment in Scenario (€149.36) is less than the after-tax future value of the same investment in Scenario (€155.36) In both cases, the investment was sold for €179.08 However, in Scenario 4, the capital gain (and capital gains tax liability) is greater because the purchase price is lower Scenario Sale Price €179.08 €179.08 Purchase Price €100 €80 Capital Gain €79.08 €99.08 Taxes Paid (30%) €23.72 €29.72 After-tax Future Value €155.36 €149.36 Note that a lower purchase price, increases the capital gains tax liability and reduces the investment’s after-tax future value Refer to Example from the curriculum 3.1.4 Wealth-Based Taxes Wealth taxes are collected annually and applied on the value of certain assets For example, many jurisdictions collect property taxes on the assessed value of real estate However, countries can also IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes collect wealth taxes on the value of financial assets The future value interest factor of an investment subject to a wealth tax (FVIFw) is calculated using the formula below: FVIFw = [(1 + r)(1 − t w )]n With an annual wealth tax rate (tw) of percent, a €100 investment with annual pre-tax growth of percent will have an after-tax value of [(1 + 0.06)(1 – tw)]10 = €146.33 at the end of 10 years Note that a percent wealth tax imposes a greater tax bite than a 30 percent tax on returns This is because wealth taxes are applied to the entire value of an asset and not simply its returns Tax drag relationships: For wealth based taxes, the three primary relationships can be summarized as: Tax drag percentage is greater than the nominal tax rate As the investment horizon increases, the tax drag increases As investment return increases, the tax drag decreases Refer to Example from the curriculum 3.2 Blended Taxing Environments Because countries typically apply different tax rates to different sources of income, portfolios are taxed at a blended rate that reflects the share of returns attributable to interest, dividends and realized capital gains The annual after-tax return (r*) for a portfolio with multiple sources of income is calculated as follows: r ∗ = r × (1 − pi t i − pd t d − pcg pcg ) In the formula above, pi is the proportion of returns derived from interest income, pd is the proportion derived from dividend income, and pcg is the proportion derived from realized capital gains When taxes are paid, the after-tax return will always be lower than the pre-tax return In Example 7, we see that an percent pre-tax return becomes a 7.02 percent return after adjusting for taxes paid on interest and dividend income as well as realized capital gains Note that taxes on unrealized capital gains have been deferred Refer to Example from the curriculum Refer to Example from the curriculum In situations where a portion of capital gains are unrealized and not taxed immediately, the effective capital gains tax rate (T*) will be less than the nominal capital gains tax rate (tcg) The formula below calculates T* by multiplying tcg by the ratio the share of returns represented by unrealized capital gains IFT Notes for the Level III Exam www.ift.world Page Taxes and Private Wealth Management in a Global Context IFT Notes to the proportion of the pre-tax return that remains after taxes have been paid: T ∗ = t cg × (1 − pi − pd − pcg ) (1 − pi t i − pd t d − pcg t cg ) Note that T* will be higher (and closer to tcg) when an unrealized capital gains account for a greater proportion of pre-tax returns Having calculated a blended after-tax rate of return (r*) and a blended tax rate (T*), it becomes possible to determine the future value interest factor for a portfolio when different sources of income are taxed at different rates FVIFTaxable = (1 + r ∗ )n (1 − T ∗ ) + T ∗ − (1 − B)t cg Refer to Example from the curriculum 3.3 Accrual Equivalent Returns and Tax Rates Determining the overall effect of taxes on portfolio returns can be challenging in blended tax environments In such cases, it is helpful to have simple measures such as the accrual equivalent return and accrual equivalent tax rate 3.3.1 Calculating Accrual Equivalent Returns The accrual equivalent return (RAE) is simply the rate (I/Y) that links a portfolio’s final after-tax value (FV) with the value of the original investment (PV) over an investment horizon of N periods 3.3.2 Calculating Accrual Equivalent Tax Rates The accrual equivalent tax rate (TAE) is the tax rate that links the accrual equivalent return (RAE) with the pre-tax return (r) and can be calculated with the formula below: TAE = − R AE r Example demonstrates how to calculate both RAE and TAE As shown in Exhibit (in Section 6.2), a higher accrual equivalent tax rate results in a lower accrual equivalent return Refer to Example from the curriculum Types of Investment Accounts This Section and Section 6.1 address: LO.d: Discuss how the tax profiles of different types of investment accounts and explain their effects on after-tax returns and future accumulations IFT Notes for the Level III Exam www.ift.world Page 10 Taxes and Private Wealth Management in a Global Context IFT Notes incentive to hold securities over a longer time horizon Additionally, this relative advantage is greater for higher rates of return Refer to Example 15 from the curriculum 6.5 After-Tax Mean-Variance Optimization This section addresses: LO.h: Demonstrate how taxes and asset location relate to mean-variance optimization Ideally, the traditional mean-variance optimization should be modified to accommodate after-tax risk and return While constructing the efficient frontier, the before tax returns should be substituted with accrual equivalent after tax returns, and the before tax risk should be substituted with risk on an after tax basis Summary a compare basic global taxation regimes as they relate to the taxation of dividend income, interest income, realized capital gains, and unrealized capital gains; Regime Common Heavy Progressive Dividend Tax Progressive Progressive Heavy Capital Gain Tax Progressive Heavy Interest Tax Progressive Light Capital Gain Tax Progressive Taxed favorably or exempt Taxed favorably or exempt Taxed favorably or exempt Taxed at ordinary rates Taxed at ordinary rates Dividends Taxed favorably or exempt Taxed at ordinary rates Taxed favorably or exempt Capital Gains Taxed favorably or exempt Taxed at ordinary rates Ordinary Tax Rate Structure Interest Income Taxed favorably or exempt Flat and Light Flat and Heavy Flat Flat Taxed favorably or exempt Taxed Taxed at Taxed favorably or ordinary favorably exempt rates or exempt Taxed Taxed Taxed favorably or favorably or favorably exempt exempt or exempt Taxed favorably or exempt Taxed at ordinary (flat) rates Taxed at ordinary (flat) rates b determine the effects of different types of taxes and tax regimes on future wealth accumulation; Future value factor IFT Notes for the Level III Exam www.ift.world Example Page 14 Taxes and Private Wealth Management in a Global Context n Returns-based taxes: accrual taxes on interest and dividends FVIFi = [1 + r(1 – ti)] Returns-based taxes: deferred capital gains FVIFcgb = (1 + r) (1 – tcg) + tcgB IFT Notes Amount = 100, r = 7%, n = 20 years and t = 20%: 20 n FV = 100 × [1 + 0.07(1 – 0.20)] = 297 Without taxes, FV = 387 Difference = 90 Tax impact = 90 / 287 = 31% which is > 20% Scenario 1: Amount = 100, cost basis = 100, r = 7%, n = 20 years and t = 20% 20 FV = 100 × [(1 + 0.07) (1 – 0.20) + 0.20] = 330 > 297 Scenario 2: Amount = 100, cost basis = 80, r = 7%, n = 20 years and t = 20% 20 Wealth-based taxes FVIFw = [(1 + r)(1 – tw)] n FV = 100 × [(1 + 0.07) (1 – 0.20) + 0.20(0.80)] = 326 Amount = 400, r = 6%, n = 10 years and t = 1%: 10 400[(1.06)(1 − 0.01)] = 648, or gain = 248 10 Without tax: 400 x 1.06 = 716, gain 316 (316 – 248) / 316 = 21.5% A 1% wealth tax consumed 21.5% of the gain c explain how investment return and investment horizon affect the tax impact associated with an investment; When investment returns are subject to accrued taxes on annual basis:  Tax drag > nominal tax rate  All else equal, as investment horizon increases  tax drag increases  All else equal, as investment return increases  tax drag increases  Given investment returns, the longer the time horizon, the greater the tax drag  Given investment time horizon, the higher the investment returns, the greater the tax drag When taxes on capital gains are deferred until the end of investment horizon:  Tax drag = tax rate  All else equal, as investment horizon increases  tax drag is unchanged  The higher the investment returns and/or the longer the investment time horizon the greater the value of a capital gain tax deferral  When marginal tax rate on investments taxed on deferred capital gain basis ≥ marginal tax rate on investments with accrual taxes  after-tax future accumulations of investments taxed on deferred capital gain basis > investments with accrual taxes, all else equal  Given investment returns, the longer the time horizon, the greater the advantage of tax deferral  Given investment time horizon, the higher the investment returns, the greater the advantage of tax deferral Wealth-Based Taxes:  As investment returns increases, tax drag (%) associated with wealth tax decreases  As investment returns increases, tax drag ($) associated with wealth tax increases  When investment returns are flat or negative, wealth tax tends to decrease principal  As investment horizon increases, reduction in investment growth caused by wealth tax increases IFT Notes for the Level III Exam www.ift.world Page 15 Taxes and Private Wealth Management in a Global Context IFT Notes Blended Tax Environment : Formula / Example Annual return after realized taxes r* = r (1 – pi ti – pd td – pcg tcg) r* = 8%[1 – (0.05 × 0.35) – (0.25 × 0.15) – (0.45 × 0.15)] = 7.02% Effective capital gains tax rate (recognizes that income and realized capital gains have been taxed) Future after-tax accumulation for each unit of currency in a taxable portfolio Accrual-equivalent return T* = tcg(1 – pi – pd – pcg)/(1 – piti – pdtd – pcgtcg) = 0.15[(1 − 0.05 − 0.25 − 0.45)/(1 − 0.05 × 0.35 − 0.25 × 0.15 − 0.45 × 0.15)] = 0.15(0.25/0.8775) = 4.27% Accrual-equivalent tax rate FVIFTaxable = (1 + r*)n(1 – T*) + T* – (1 – B)tcg   100 [(1.0702)5(1 − 0.0427) + 0.0427 − (1 − 1.00)0.15] = 139 If we start with 100 and end with an after-tax amount of 139 after years then: 100(1 + RAE)5 = 139 r(1 – TAE) = RAE d discuss the tax profiles of different types of investment accounts and explain their effects on after-tax returns and future accumulations; Taxable Account Tax-Deferred Accounts (TDAs) Tax-Exempt Accounts     Description Contributions are after-tax Returns are taxed Contribution are pre-tax Returns accumulate on taxdeferred basis until funds are withdrawn; taxed at ordinary rates Contributions are after-tax Returns are not taxed Future Value Discussed previously 𝐅𝐕𝐈𝐅𝐓𝐃𝐀 = (𝟏 + 𝒓)𝒏 (𝟏 − 𝑻𝒏 ) 𝐅𝐕𝐈𝐅𝐓𝐚𝐱𝐄𝐱 = (𝟏 + 𝒓)𝒏 If future taxes are expected to be lower than current taxes  tax-deferred accounts are better If future taxes are expected to be higher than current taxes  tax-exempt accounts are better Tax alpha: value generated by using techniques that effectively manage tax liabilities Asset location decision: choice of where to place the specific assets  Heavily-taxed assets should be held in tax-sheltered accounts  Lightly-taxed asset should be held in taxable accounts e explain how taxes affect investment risk;   For assets in taxable accounts, taxes reduce both investment risk and return Investors after-tax risk = σ (1 - T) For assets in TDA’s and tax exempt accounts, investor bear all risk associated with returns f discuss the relation between after-tax returns and different types of investor trading behavior; IFT Notes for the Level III Exam www.ift.world Page 16 Taxes and Private Wealth Management in a Global Context IFT Notes Investor Type Trading frequency Accrual equivalent return Accrual equivalent tax rate Trader frequently Active trader Less frequently Passive Buy and hold Tax-exempt Buy and hold lowest > Trader but < passive and taxexempt investor > Trader and active trader but < tax-exempt investor highest highest < trader but > passive and tax-exempt investor < Trader and active trader but > tax-exempt investor lowest g explain tax loss harvesting and highest-in/ first-out (HIFO) tax lot accounting;  Tax loss harvesting: realizing capital losses to offset taxable gains in that tax year  decrease in the current year’s tax liability It is best used when tax rates are relatively high Deferring taxes may not be a desirable strategy if tax rates are expected to increase  Highest-in, first-out (HIFO): highest cost basis lots are sold first to defer the tax on the low cost basis lots, resulting in decrease in current capital gain taxes Reinvesting current year’s tax savings increases the after-tax principal investment h demonstrate how taxes and asset location relate to mean– variance optimization    Traditional mean-variance optimization should be modified to accommodate after-tax risk and return Mean variance optimization algorithm should use after-tax standard deviations of returns and accrual equivalent returns rather than pretax standard deviations and pretax returns An after-tax portfolio optimization model that optimizes asset allocation also optimizes asset location Examples from the Curriculum Example Tax Rates Vanessa Wong is a new client living in a jurisdiction with a progressive tax rate structure She expects to have taxable ordinary income of €70,000 this year The tax rate structure in her jurisdiction is as follows: Taxable Income (€) Over Up to Tax on Column Percentage on Excess Over Column 30,000 — 20 30,000 60,000 6,000 30 60,000 90,000 15,000 40 90,000 27,000 50 Wong’s marginal tax rate is closest to: A 35% IFT Notes for the Level III Exam www.ift.world Page 17 Taxes and Private Wealth Management in a Global Context IFT Notes B 40% C 50% Wong’s average tax rate is closest to: A 27% B 35% C 40% Solution to 1: B is correct Wong’s marginal tax rate is 40 percent Because Wong’s income is over €60,000 but below €90,000, her next €1 of income would be taxed at 40 percent Solution to 2: A is correct Wong’s tax liability would be €15,000 + 0.40 (€70,000 − €60,000) = €19,000 With a tax liability of €19,000 and taxable income of €70,000, her average tax rate would be about 27 percent (€19,000/€70,000) Back to Notes Example Accrual Taxes Vladimir Kozloski is determining the impact of taxes on his expected investment returns and wealth accumulations Kozloski lives in a tax jurisdiction with a flat tax rate of 20 percent which applies to all types of income and is taxed annually Kozloski expects to earn percent per year on his investment over a 20 year time horizon and has an initial portfolio of €100,000 What is Kozloski’s expected wealth at the end of 20 years? What proportion of potential investment gains were consumed by taxes? Solution to 1: FV = €100,000 × FVIFi = €100,000 × [1 + 0.07(1 – 0.20)]20 = €297,357 Solution to 2: Ignoring taxes, FV = €100,000 [1 + 0.07]20 = €386,968 The difference between this and the after tax amount accumulated from above is €89,611 The proportion of potential investment gains consumed by taxes was €89,611/€286,968 = 31.23 percent IFT Notes for the Level III Exam www.ift.world Page 18 Taxes and Private Wealth Management in a Global Context IFT Notes Back to Notes Example Deferred Capital Gains Assume the same facts as in Example Kozloski invests €100,000 at percent However, the return comes in the form of deferred capital gains that are not taxed until the investment is sold in 20 years hence What is Kozloski’s expected wealth at the end of 20 years? What proportion of potential investment gains were consumed by taxes? Solution to 1: FV = €100,000 × FVIFcg = €100,000 × [(1 + 0.07)20(1 – t) + t] = €100,000 × [(1 + 0.07)20(1 – 0.20) + 0.20] = €329,575 Solution to 2: Ignoring taxes, FV = €100,000 [1 + 0.07]20 = €386,968 The difference between this and the after-tax amount accumulated from above is €57,393 The proportion of potential investment gains consumed by taxes was €57,393/€286,968 = 20.0 percent This result compares favorably to the potential investment gains consumed by taxes in Example Back to Notes Example Cost Basis Continuing with the facts in Examples and 3, Kozloski has a current investment with a market value of €100,000 and cost basis of €80,000 The stock price grows at percent per year for 20 years Express the cost basis as a percent of the current market value What is Kozloski’s expected wealth after 20 years? Solution to 1: Cost basis/Current market value = B = €80,000/€100,000 = 0.80 Solution to 2: FV = €100,000 × FVIFcbg = €100,000 × [(1 + 0.07)20(1 – 0.20) + 0.20(0.80)] IFT Notes for the Level III Exam www.ift.world Page 19 Taxes and Private Wealth Management in a Global Context IFT Notes = €325,575 This amount is €4,000 smaller than Kozloski’s expected wealth in Example 3, in which it was assumed that the cost basis equaled the current market value Back to Notes Example Wealth Tax Olga Sanford lives in a country that imposes a wealth tax of 1.0 percent on financial assets each year Her €400,000 portfolio is expected to return percent over the next ten years What is Sanford’s expected wealth at the end of ten years? What proportion of investment gains was consumed by taxes? Solution to 1: FV = €400,000[(1.06)(1 − 0.01)]10 = €647,844 Solution to 2: Had the wealth tax not existed, FV = €400,000(1.06)10 = €716,339 This sum represents a €316,339 investment gain compared to a €247,844 gain in the presence of the wealth tax Therefore, the one percent wealth tax consumed 21.65 percent of the investment gain (i.e., (€316,339 − €247,844)/€316,339) Back to Notes Example Blended Tax Environment Zahid Kharullah has a balanced portfolio of stocks and bonds At the beginning of the year, his portfolio has a market value of €100,000 By the end of the year, the portfolio was worth €108,000 before any annual taxes had been paid, and there were no contributions or withdrawals Interest of €400 and dividends of €2,000 were reinvested into the portfolio During the year, Kharullah had €3,600 of realized capital gains These proceeds were again reinvested into the portfolio What percentage of Kharullah’s return is in the form of interest? What percentage of Kharullah’s return is in the form of dividends? What percentage of Kharullah’s return is in the form of realized capital gain? What percentage of Kharullah’s return is in the form of deferred capital gain? IFT Notes for the Level III Exam www.ift.world Page 20 Taxes and Private Wealth Management in a Global Context IFT Notes Solution to 1: pi = €400/€8,000 = 0.05 or percent Solution to 2: pd = €2,000/€8,000 = 0.25 or 25 percent Solution to 3: pcg = €3,600/€8,000 = 0.45 or 45 percent Solution to 4: Unrealized gain = €8,000 − €400 − €2,000 − €3,600 = €2,000 Expressed as a percentage of return, €2,000/€8,000 = 0.25, or 25 percent The unrealized gain is the portion of investment appreciation that was not taxed as either interest, dividends, or realized capital gain Back to Notes Example Blended Tax Environment: After Tax Return Continuing with the facts in Example 6, assume that dividends and realized capital gains are taxed at 15 percent annually while interest is taxed at 35 percent annually What is the annual return after realized taxes? Assuming taxes are paid out of the investment account, what is the balance in the account at the end of the first year? Solution to 1: r* = r(1 – piti – pdtd – pcgtcg) = 8%[1 – (0.05 × 0.35) – (0.25 × 0.15) – (0.45 × 0.15)] = 7.02% Solution to 2: Using the income data from above, Income Type Income Amount (€) Tax Rate (%) Tax Due (€) Interest 400 35 140 Dividends 2,000 15 300 IFT Notes for the Level III Exam www.ift.world Page 21 Taxes and Private Wealth Management in a Global Context Realized capital gains 3,600 15 IFT Notes 540 Total tax due 980 After paying taxes there would be €107,020 in the account (€108,000 − €980) Note that this is consistent with the 7.02 percent return computed for the first question Back to Notes Example Blended Tax Environment: Future Long Term Accumulation Continuing with the facts in the previous example, assume there is a five-year investment horizon for the account Annual accrual taxes will be paid out of the account each year with the deferred tax on previously unrealized capital gains paid at the end of the five-year horizon The account is rebalanced annually Consider a €100,000 portfolio with the return and tax profile listed in Panel A of Exhibit What is the expected after-tax accumulation in five years? Panel A: Tax Profile Annual Distribution Rate (p) Tax Rate (T) Ordinary Income (i) 5% 35% Dividends (d) 25% 15% Capital Gain (cg) 45% 15% Investment Horizon (n) years Average Return (r) 8% Cost Basis €100,000 Panel B: Intermediate Accumulation Calculations Annual after-tax return (r*) 7.02% * Effective capital gains tax rate (T ) 4.27% In this case, 25 percent of the return is composed of dividends; percent is composed of realized shortterm capital gains; and 45 percent is composed of realized long-term gains These figures imply that the remaining 25 percent (i.e., − 0.05 − 0.25 − 0.45) of portfolio returns are deferred capital gains and not taxed until the end of the investment horizon The annual return after realized taxes, r*, is 0.08[1 − (0.05)(0.35) − (0.25)(0.15) − (0.45)(0.15)] = 7.02 percent as computed previously This figure reflects the annual return after having accounted for the tax drag imposed by annually levied taxes on the portion of return composed of elements like dividends, interest, and realized capital gains It does not take into account, however, tax obligations from gains not yet realized; that effect is considered in the effective capital gains tax rate, T*, which equals 0.15[(1 − 0.05 − 0.25 − 0.45)/(1 − 0.05 × 0.35 − 0.25 × 0.15 − 0.45 × 0.15)] = 0.15(0.25/0.8775) = 4.27 percent The figure is relatively low in this example because a relatively small proportion of return, 25 percent, is subject to deferred capital gains tax IFT Notes for the Level III Exam www.ift.world Page 22 Taxes and Private Wealth Management in a Global Context IFT Notes Because the cost basis and the current market value portfolio are both €100,000, the cost basis expressed as a percent of current market value is 1.00 Substituting these intermediate results into Equation 5, the expected future accumulation of the portfolio in years equals €100,000[(1 + r*)n(1 – T*) + T* − (1 − B)tcg] = €100,000[(1.0702)5(1 − 0.0427) + 0.0427 − (1 − 1.00)0.15] = €138,662 Back to Notes Example Accrual Equivalent Return We extend Example with the same facts repeated here: Vladimir Kozloski is determining the impact of taxes on his expected investment returns and wealth accumulations Kozloski lives in a tax jurisdiction with a flat tax rate of 20 percent, which applies to all types of income and is taxed annually He expects to earn percent per year on his investment over a 20-year time horizon and has an initial portfolio of €100,000 The percent return is expected to come from deferred capital gains, which are not taxed until sold in 20 years Kozloski’s expected wealth at the end of 20 years is: FV = €100,000 × FVIFcg = €100,000 × [(1 + 0.07)20(1 – 0.2) + 0.2] = €329,575 What is the accrual equivalent return? What is the accrual equivalent tax rate? Solution to 1: €100,000(1 + RAE)20 = €329,575 RAE = 6.1446 percent Kozloski would be just as well off if he could find a tax-free investment earning 6.1446 percent Solution to 2: 0.07(1 – TAE) = 0.061446 TAE = 12.22 percent This rate is lower than the stated tax rate on dividends because there is an advantage from the deferral of taxes Back to Notes Example 10 Comparing Accumulations of Account Types Extending Examples and 3, recall that Vladimir Kozloski lives in a tax jurisdiction with a flat tax rate of IFT Notes for the Level III Exam www.ift.world Page 23 Taxes and Private Wealth Management in a Global Context IFT Notes 20 percent which applies to all types of income Kozloski expects to earn percent per year on his investment over a 20 year time horizon and has an initial portfolio of €100,000 Assume that Kozloski has the following current investments: €100,000 invested in a taxable account earning percent taxed annually €100,000 invested in a taxable account earning percent deferred capital gains (cost basis = €100,000) €100,000 invested in a tax deferred account earning percent €100,000 invested in a tax exempt account earning percent Compute the after-tax wealth for each account at the end of 20 years assuming all assets are sold and accounts liquidated at the end of 20 years and assuming a tax rate of 20 percent Solution to 1: FVIF = €100,000[1 + 0.07(1 − 0.20)]20 = €297,357 Solution to 2: FVIF = €100,000[(1 + 0.07)20(1 − 0.20) + 0.20] = €329,575 Solution to 3: FVIF = €100,000[(1 + 0.07)20(1 − 0.20)] = €309,575 Solution to 4: FVIF = €100,000[(1 + 0.07)20] = €386,968 Back to Notes Example 11 Choosing Among Account Types Bettye Mims would like to invest for retirement and is willing to reduce this year’s spending by €3,000 She will invest €3,000 after taxes this year and is in a 25 percent tax bracket, which is the top marginal tax rate in her jurisdiction Mims is considering three types of accounts but would invest in the same portfolio which is expected to have a pre-tax return of percent annually If invested in a taxable account the income would be taxed each year at the same 25 percent rate Assuming Mims will make a single contribution today and withdraw all funds—paying any necessary taxes in 30 years—which of the following accounts will result in the largest after-tax accumulation?  Account A A taxable account with an initial investment of €3,000 IFT Notes for the Level III Exam www.ift.world Page 24 Taxes and Private Wealth Management in a Global Context   IFT Notes Account B A tax deferred account, where Mims can make a €4,000 tax deductible contribution (a €3,000 after tax cost to Mims) Account C A tax exempt account, where a €3,000 contribution is not deductible Solution: The taxable account would accumulate €11,236 after taxes: For A, FVIF = €3,000[1 + 0.06(1 – 0.25)]30 = €11,236 The tax deferred account would accumulate €17,230 after taxes: For B, FVIF = €4,000[(1 + 0.06)30(1 – 0.25)] = €17,230 The tax exempt account would also accumulate €17,230 after taxes: For C, FVIF = €3,000[(1 + 0.06)30] = €17,230 Both B and C achieve the same after-tax accumulation assuming her tax rates in the contribution year and withdrawal year are the same Back to Notes Example 12 Tax Loss Harvesting: Current Tax Savings Eduardo Cappellino has a €1,000,000 portfolio held in a taxable account The end of the 2008 tax year is approaching and Cappellino has recognized €100,000 worth of capital gains His portfolio has securities that have experienced €60,000 of losses These securities have not yet been sold and their losses are therefore unrecognized Cappellino could sell these securities and replace them with similar securities expected to earn identical returns.23 The federal government taxes capital gains at 20 percent Without making any further transactions, how much tax does Cappellino owe this year? How much tax will Cappellino owe this year if he sells the securities with the €60,000 loss? How much tax will Cappellino save this year if he sells the securities with the €60,000 loss? Solution to 1: Capital gain tax = 0.20 × €100,000 = €20,000 Solution to 2: If Cappellino realizes €60,000 of losses, the net gain will be reduced to €40,000 New capital gain tax = 0.20 × (€100,000 − €60,000) = €8,000 IFT Notes for the Level III Exam www.ift.world Page 25 Taxes and Private Wealth Management in a Global Context IFT Notes Solution to 3: Tax Savings = €20,000 − €8,000 = €12,000 Back to Notes Example 13 Tax Loss Harvesting: Tax Deferral In the previous example, the securities with an unrealized loss have a current market value of €110,000 and cost basis of €170,000 (an unrealized loss of €60,000) Cappellino could: Option A Hold the securities with the unrealized loss, or Option B Sell the securities in 2008 and replace them with securities offering the same return Next tax year (2009), the securities increase in value to €200,000 and the securities are sold regardless of which option Cappellino chooses Calculate Cappellino’s 2009 tax liability if he holds the securities until year end 2009 Calculate Cappellino’s 2009 tax liability if he recognizes the loss today in 2008, replaces them with securities offering the same return, and realizes the capital gain at year end 2009 Compare the total two-year tax liability under both options using the 2008 tax liability computed in Example 12, in which the 2008 tax liability was €20,000 if the loss was not realized and €8,000 if the loss was realized Solution to 1: Capital gain tax = 0.20(€200,000 − €170,000) = €6,000 Solution to 2: If Cappellino recognizes the loss in 2008 and replaces the securities, the basis will be reset to €110,000 from €170,000 Capital gain tax in 2009 = 0.20(€200,000 − €110,000) = €18,000 Solution to 3: The two-year tax liability for both options is the same: IFT Notes for the Level III Exam www.ift.world Page 26 Taxes and Private Wealth Management in a Global Context 2008 (€) 2009 (€) Total (€) Option A 20,000 6,000 26,000 Option B 8,000 18,000 26,000 IFT Notes Although the two-year tax liability does not change, an advantage of tax loss harvesting is pushing a portion of the tax liability into subsequent years Back to Notes Example 14 Tax Loss Harvesting: Adding Net-of-Tax Principal In the previous example, suppose Cappellino reinvests the 2008 tax savings if he sells the securities with an unrealized loss of €60,000 His two options are therefore: Option A Hold the securities, or Option B Sell the securities, and reinvest the proceeds and the tax savings in nearly identical securities In 2009, the securities experience an 81.81 percent increase regardless of which option Cappellino chooses Calculate the securities’ pretax value next year if he holds the securities Calculate the securities’ pretax value next year if he recognizes the loss, and reinvests the proceeds and the tax savings in nearly identical securities What will the after-tax value be under both options if the securities are sold the next year? Solution to 1: FV = €110,000(1.8181) = €200,000 (approximately) Solution to 2: If Cappellino replaces the securities and invests the tax savings of €12,000, the invested capital will become €110,000 + €12,000 = €122,000 FV = €122,000(1.8181) = €221,808 Solution to 3: IFT Notes for the Level III Exam www.ift.world Page 27 Taxes and Private Wealth Management in a Global Context IFT Notes The new capital gain tax for Option B at the end of the next tax year is 0.20(€221,808 − €122,000) = €19,962 Pretax (€) Tax (€) After-Tax (€) Option A 200,000 6,000 194,000 Option B 221,808 19,962 201,846 Another advantage of tax loss harvesting is increasing the net-of-tax capital invested in the portfolio Back to Notes Example 15 Long-Term Gain Gretel Hazburger is considering two different portfolio strategies The first is a hyper-active markettiming trading strategy that is expected to yield a pretax return of 12 percent All gains will be recognized each year and taxed at the short term capital gain rate of 50 percent Alternatively, a less active tactical asset allocation trading strategy is expected to yield a pretax return of 10 percent All gains will be recognized each year but classified as long term and taxed at 30 percent Which strategy is likely to produce a better after tax return? What pretax return is required on the market timing strategy to produce the same after-tax return as the tactical asset allocation strategy? Solution to 1: After-tax return to market timing = 0.12(1 − 0.50) = 0.06 = percent After-tax return to tactical asset allocation = 0.10 (1 − 0.30) = 0.07 = percent The tactical asset allocation strategy produces a better return Solution to 2: Required return for market timing = 0.07/(1 − 0.50) = 0.14 = 14 percent Back to Notes IFT Notes for the Level III Exam www.ift.world Page 28 ... Wealth-based Taxes Wealth-based taxes come in two forms: Taxes on transferring wealth IFT Notes for the Level III Exam www .ift. world Page Taxes and Private Wealth Management in a Global Context IFT Notes. .. 30 0 IFT Notes for the Level III Exam www .ift. world Page 21 Taxes and Private Wealth Management in a Global Context Realized capital gains 3, 600 15 IFT Notes 540 Total tax due 980 After paying taxes. .. percent IFT Notes for the Level III Exam www .ift. world Page 18 Taxes and Private Wealth Management in a Global Context IFT Notes Back to Notes Example Deferred Capital Gains Assume the same facts as