CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r09 taxes and private wealth management summary

Level III Taxes and Private Wealth Management Summary Basic Global Taxation Regimes Regime Common Progressive Heavy Dividend Tax Heavy Capital Gain Tax Heavy Interest Tax Light Capital Gain Tax Flat and Light Flat and Heavy Ordinary Tax Rate Structure Progressive Progressive Progressive Progressive Progressive Flat Flat Interest Income Taxed favorably or exempt Taxed favorably or exempt Taxed favorably or exempt Taxed favorably or exempt Taxed favorably or exempt Taxed Taxed at Dividends favorably or ordinary rates exempt Capital Gains Taxed favorably or exempt Taxed favorably or exempt Taxed at ordinary Taxed at ordinary rates rates Taxed favorably or exempt Taxed favorably or exempt Taxed at ordinary rates Taxed favorably or exempt Taxed at ordinary (flat) rates Taxed at ordinary rates Taxed favorably or exempt Taxed favorably or exempt Taxed favorably or exempt Taxed at ordinary (flat) rates www.ift.world Impact of Taxes on Future Wealth Future value factor Example Returns-based taxes: accrual taxes on interest and dividends FVIFi = [1 + r(1 – ti)]n Amount = 100, r = 7%, n = 20 years and t = 20%: FV = 100 × [1 + 0.07(1 – 0.20)]20 = 297 Without taxes, FV = 387 Difference = 90 Tax impact = 90 / 287 = 31% which is > 20% Returns-based taxes: deferred capital gains FVIFcgb = (1 + r)n(1 – tcg) + tcgB Scenario 1: Amount = 100, cost basis = 100, r = 7%, n = 20 years and t = 20% FV = 100 × [(1 + 0.07)20(1 – 0.20) + 0.20] = 330 > 297 Scenario 2: Amount = 100, cost basis = 80, r = 7%, n = 20 years and t = 20% FV = 100 × [(1 + 0.07)20(1 – 0.20) + 0.20(0.80)] = 326 Wealth-based taxes FVIFw = [(1 + r)(1 – tw)]n www.ift.world Amount = 400, r = 6%, n = 10 years and t = 1%: 400*(1.06)(1 − 0.01)+10 = 648, or gain = 248 Without tax: 400 x 1.0610 = 716, gain 316 (316 – 248) / 316 = 21.5% A 1% wealth tax consumed 21.5% of the gain Impact of Investment Return and Time Horizon on Taxes 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 www.ift.world 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 T* = tcg(1 – pi – pd – pcg)/(1 – piti – pdtd – pcgtcg) (recognizes that income and = 0.15*(1 − 0.05 − 0.25 − 0.45)/(1 − 0.05 × 0.35 − 0.25 × 0.15 − 0.45 × 0.15)] realized capital gains have been = 0.15(0.25/0.8775) = 4.27% taxed) Future after-tax accumulation for each unit of currency in a taxable portfolio FVIFTaxable = (1 + r*)n(1 – T*) + T* – (1 – B)tcg   Accrual-equivalent return If we start with 100 and end with an after-tax amount of 139 after years then: 100(1 + RAE)5 = 139 Accrual-equivalent tax rate r(1 – TAE) = RAE 100 [(1.0702)5(1 − 0.0427) + 0.0427 − (1 − 1.00)0.15+ = 139 www.ift.world Investment Accounts – Tax Profiles • • • • Description Future Value Taxable Account Contributions are after-tax Returns are taxed Discussed previously Tax-Deferred Accounts (TDAs) Contribution are pre-tax 𝐅𝐕𝐈𝐅𝐓𝐃𝐀 = 𝟏 + 𝒓 𝒏 (𝟏 − 𝑻𝒏 ) Returns accumulate on tax-deferred basis until funds are withdrawn; taxed at ordinary rates Tax-Exempt Accounts Contributions are after-tax Returns are not taxed 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 www.ift.world Taxes and Investment Risk • For assets in taxable accounts, taxes reduce both investment risk and return • For assets in TDA’s and tax exempt accounts, investor bear all risk associated with returns Investors after-tax risk = σ (1 - T) After-tax Returns and Trading Behavior • Many tax regimes encourage longer term investments • If tax on short term gains > tax on long term gains  Reduce short-term trading • Active managers must earn greater pre-tax returns than passive managers to offset tax drag of active trading www.ift.world Tax Loss Harvesting, HIFO and MVO This strategy postpones the Tax loss harvesting: realizing capital losses to offset taxable gains in that tax payment of taxes year  decrease in the current year’s tax liability 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 • 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 www.ift.world ... Impact of Taxes on Future Wealth Future value factor Example Returns-based taxes: accrual taxes on interest and dividends FVIFi = [1 + r(1 – ti)]n Amount = 100, r = 7%, n = 20 years and t = 20%:... 716, gain 31 6 (31 6 – 248) / 31 6 = 21.5% A 1% wealth tax consumed 21.5% of the gain Impact of Investment Return and Time Horizon on Taxes When investment returns are subject to accrued taxes on... in taxable accounts www.ift.world Taxes and Investment Risk • For assets in taxable accounts, taxes reduce both investment risk and return • For assets in TDA’s and tax exempt accounts, investor