Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com FinQuiz.com CFA Level III Item-set - Solution Study Session June 2018 Copyright © 2010-2018 FinQuiz.com All rights reserved Copying, reproduction or redistribution of this material is strictly prohibited info@finquiz.com FinQuiz.com © 2018 - All rights reserved Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com FinQuiz Level III 2018 – Item-sets Solution Reading 9: Taxes and Private Wealth Management in a Global Context Question ID: 12500 Correct Answer: C Larson’s marginal tax rate is 46% as the portfolio’s income is above $45,000 but below $70,000 Her next $1 of income would be taxed at 46% Question ID: 12501 Correct Answer: B Larson’s tax liability at the end of the year would be $15,650 + 0.46 ($65,000 – $45,000) = $24,850 Thus the average tax liability would be approximately 38% ($24,850/$65,000) Question ID: 12502 Correct Answer: C The formula for calculating the expected after-tax accumulation after a period of n years is as follows: FVIFTAXABLE = (1 + r*) n (1 – T*) + T* − (1 – B)tcg Prior to calculating this value, it is necessary to calculate r* The after-tax annual return (r*) earned on Larson’s portfolio at the end of the year is calculated as follows: r* = r(1 – piti - pdtd – pcgtcg) = 7.5% [1 – (0.2 × 0.14) – (0.5 × 0.14) – (0.15 × 0.12)] = 6.63% The effective capital gains tax rate on Larson’s portfolio is calculated as follows: T* = tcg(1 – pi – pd – pcg)/ (1 – piti - pdtd – pcgtcg) = 0.12 (1 – 0.2 – 0.5 – 0.15)/ [1 – (0.2 × 0.14) – (0.5 × 0.14) – (0.15 × 0.12)] = 0.02036 or 2.036% FVIFTAXABLE = $500,000 [(1 + 6.63%) 20 (1 – 2.036%) + 2.036% − (1 – 1)(12%)] = $1,778,759.95 ≈ $1,780,000 Question ID: 12503 Correct Answer: C The accrual equivalent after-tax return on Larson’s portfolio is calculated as follows: $500,000 (1 + RAE) 20 = $1,778,759.95 RAE = 0.0655096 or ≈ 6.55% FinQuiz.com © 2018 - All rights reserved Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com Question ID: 12504 Correct Answer: A The after-tax market values and after-tax weights for the $200,000 portfolio is calculated after deducting 40% taxes from the TDA account Account Type Pre-tax Market Value ($) TDA 60,000 Tax-Exempt 140,000 Total Portfolio 200,000 *60,000 (1 – 0.4) = $36,000 Pre-Tax Market Weights (%) 30% 70% 100% After-Tax Market Value ($) 36,000* 140,000 176,000 After-Tax Weights (%) 20.5 79.5 100.0 Question ID: 12505 Correct Answer: C Amongst the three regimes (Heavy Interest Tax, Common Progressive, Light Capital Gain Tax), the Light Capital Gain tax regime is a progressive tax regime taxing dividends and interest income at ordinary rates and capital gains at favorable rates Question ID: 11239 Correct Answer: B The effective capital gains tax rate can be found using the following formula: (ିࡼ`ࡵ ାࡼࡰశ ࡼࡳ ) ࢀࡱࡳ = ࢀࡳ ି(ࡼ ࢀ ାࡼ ࢀାࡼ ࢀ ) ࡵ ࡵ ࡰ ࡳ ࡳ ሺି.ି.ି.ሻ = ( ) ିሺ.×.ା.×.ା.×.ሻ .ૡ = × .ૡૠૡ = 3.189% Question ID: 11240 Correct Answer: B First, we will calculate the effective tax rate for Harris’ portfolio using the following formula: ܶாீ (ଵି` ାವశ ಸ ) = ܶீ ଵି( ் ାವ ்ାಸ ்ಸ ) ሺଵି.ଵି.ଷି.ଷଶሻ = (0.10)ଵିሺ.ଵ×.ଷା.ଷ×.ଶା.ଷଶ×.ଵሻ .ଶ଼ = 0.10 × .଼଼ = 3.189% Now we can calculate the return after realized taxes using the following equation Value in 10 years = $500,000 (1 + R ୖ )ଵ(1–Tେୋ ) + Tେୋ –(1–B) Tେୋ $1,503,400 = $500,000 (1 + R ୖ )ଵ (1–0.03189) + 0.03189– (1–0.75) 0.10 FinQuiz.com © 2018 - All rights reserved Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com Solving the above equation we get, ܴோ் = 12% Question ID: 11241 Correct Answer: B A heavy dividend tax regime has a progressive income tax structure It has a favorable treatment for interest income and capital gains A light capital gain tax regime has a progressive income tax structure and a favorable treatment for capital gains A flat and heavy regime has a flat income tax structure and a favorable treatment for interest income 10 Question ID: 11242 Correct Answer: A Anderson’s first statement is correct Accrual taxes are paid periodically The tax drag increases as the time horizon increases and as the investment return increases Return and investment horizon have a multiplicative effect on the tax drag associated with future accumulations The impact of return is greater for long investment horizons, and the impact of investment horizon is greater for higher returns Anderson’s second statement is incorrect The proportion of investment growth consumed by wealth based taxes decreases as return increases 11 Question ID: 11243 Correct Answer: C Using the tax rate of 30% given in option C we can perform the following calculations: The after tax value of the TDA account is $170,000(1– 0.30) = $119,000 The after-tax value of the tax-exempt account is $70,000 The total after-tax value of the portfolio is $189,000 Stocks represent 37% of the portfolio whereas bonds represent 63% of the portfolio Alternatively, the tax rate can be calculated as follows: 37% x X = $70,000 X = $189,000 Where X = After tax portfolio value $189,000 – $70,000 = $119,000 FinQuiz.com © 2018 - All rights reserved Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com $119,000 = $170,000(1 – tax rate) Tax rate = 30% 12 Question ID: 11244 Correct Answer: B Smith is incorrect in agreeing with Anderson’s first statement Tax savings realized in a given tax year from the tax loss harvesting overstate the true gain Selling a security at a loss and reinvesting the proceeds in a similar security effectively resets the cost basis to the lower market value, potentially increasing future tax liabilities In other words, taxes saved now may be simply postponed Smith is incorrect in disagreeing with Anderson’s second statement The efficient frontier of portfolios should ideally be viewed on an after-tax basis Furthermore, because the tax status of an investment depends on the type of account it is in, the same asset could appear on the efficient frontier in both taxable and non-taxable form 13 Question ID: 19036 Correct Answer: A The capital gains on Jones’ portfolio were A$1,500,000 × 0.25 = $375,000 If losses are not realized, capital gain tax will be A$112,500 (A$375,000 × 30%) The same year, unrealized capital losses were A$100,000 – A$70,000 = A$30,000 If these securities are sold in 2010 and the capital losses are realized, the capital gain will reduce to A$345,000 (A$375,000 – A$30,000) The new capital gain tax is: A$345,000 × 30% = A$103,500 Tax savings = A$112,500 – A$103,500 = A$9,000 14 Question ID: 19037 Correct Answer: C Harvesting losses is not an optimal strategy when the investor currently faces a relatively low tax environment and will face higher taxes in subsequent periods In this scenario, the best strategy will be to defer harvesting losses A is incorrect Tax loss harvesting has more value when securities have potentially high volatility B is incorrect Cumulative tax alphas from tax loss harvesting will increase over time FinQuiz.com © 2018 - All rights reserved Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com 15 Question ID: 19038 Correct Answer: C The after-tax value of the TDA account is 0.6 × A$5,000,000 × (1 – 0.4) = A$1,800,000 After-tax value of the tax-exempt account = A$5,000,000 × 0.4 = A$2,000,000 Total after-tax value of the portfolio = A$1,800,000 + A$2,000,000 = A$3,800,000 Stock represents A$2,000,000/A$3,800,000 = 52.6% of the total after-tax value Bonds represent A$1,800,000/A$3,800,000 = 47.4% of the total after-tax value 16 Question ID: 19039 Correct Answer: B In a deferred capital gain taxation environment, the future value of an accumulation equals: FV = (1 + r)n(1 – tcg)+ tcg The future accumulation of Po’s portfolio in a deferred capital gain taxation environment is: 250,000[(1 + 0.08)15(1 – 0.25) + 0.25] = A$657,281.71 In an annual taxation environment, the future value of an accumulation equals: FV = [1 + r(1 – ti)]n The future accumulation of Po’s portfolio in an annual taxation environment is: 250,000[(1 + 0.08(1 – 0.25)]15 = A$599,139.55 The deferred capital gain environment accumulates to A$657,281.71/A$599,139.55 = 1.097 times the amount accumulated in an annual taxation environment FinQuiz.com © 2018 - All rights reserved Reading Taxes and Private Wealth Management in a Global Context FinQuiz.com 17 Question ID: 19040 Correct Answer: C Comment is incorrect In a deferred capital gains environment, tax drags remain constant regardless of the time horizon This is because, according to the formula for calculating the future value accumulation, in such an environment, after-tax investment gain is equal to the pre-tax investment gain multiplied by one minus the tax rate Comment is incorrect The advantages of tax deferral can be offset or eliminated if securities taxed on an accrual-basis have greater risk-adjusted returns That is, the greater the risk-adjusted returns on assets taxed on an accrual basis, the lower the relative accumulations Therefore, the greater the future value of the accumulation in an annual taxation environment, the greater the chances that the advantages of tax deferral may be lost 18 Question ID: 19041 Correct Answer: A A$80,000 of Po’s income will generate taxes of A$17,550 The remaining A$70,000 (A$150,000 – A$80,000) will generate taxes of A$25,900 (A$70,000 × 0.37) The average tax rate is equal to (A$17,550 + A$25,900)/A$150,000 = 28.97% Marginal tax rate is the Tax rate paid on highest dollar of income, that is, 37% here The marginal tax rate exceeds the average tax rate by 8.03% (37% – 28.97%) FinQuiz.com © 2018 - All rights reserved ... 0. 12 (1 – 0 .2 – 0.5 – 0.15)/ [1 – (0 .2 × 0.14) – (0.5 × 0.14) – (0.15 × 0. 12) ] = 0. 02 036 or 2. 036 % FVIFTAXABLE = $500,000 [(1 + 6. 63% ) 20 (1 – 2. 036 %) + 2. 036 % − (1 – 1)( 12% )] = $1,778,7 59. 95... annual taxation environment is: 25 0,000[(1 + 0.08(1 – 0 .25 )]15 = A$ 599 , 1 39 .55 The deferred capital gain environment accumulates to A$657 ,28 1.71/A$ 599 , 1 39 .55 = 1. 097 times the amount accumulated... gain will reduce to A $34 5,000 (A $37 5,000 – A $30 ,000) The new capital gain tax is: A $34 5,000 × 30 % = A$1 03, 500 Tax savings = A$1 12, 500 – A$1 03, 500 = A $9, 000 14 Question ID: 19 037 Correct Answer: