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2018 Study Session # 4, Reading # “TAXES AND PRIVATE WEALTH MANAGEMENT IN A GLOBAL CONTEXT” TDA = Tax Deferred Accounts SD = Standard Deviation LIFO = Lowest in, First Out HIFO = Highest in, First Out OVERVIEW OF GLOBAL INCOME TAXSTRUCTURES Sources of Govt Tax Revenue Taxes on Income Wealth-Based Taxes Taxes on ordinary & investment income Taxes on the holding of certain types of property Wealth transfer taxes Taxes on Consumption Sales tax Value added taxes 2.1 International Comparisons of Income Taxation 2.2 Common Elements Types of tax structures: Progressive tax rate structure ⇒tax rate as income Flat tax rate structure ⇒ all taxable income is taxed at the same rate Marginal tax rate ⇒ rate paid on the next $ of income earned 2.3 General Income Tax Regimes Classification of Income Tax Regime Regime Ordinary Tax Rate Structure Interest Income Dividends Capital Gains l-Common Progressive Progressive – Heavy Dividend Tax Progressive – Heavy Capital Gain Tax Progressive 4- Heavy Interest Tax Progressive – Light Capital Gain Tax Progressive – Flat and Light - Flat and Heavy Flat Flat Some interest taxed at favorable rates or exempt Some dividends taxed at favorable rates or exempt Some capital gains taxed favorably or exempt Some interest taxed at favorable rates or exempt Taxed at ordinary rates Some interest taxed at favorable rates or exempt Some dividends taxed at favorable rates or exempt Taxed at ordinary rates Taxed at ordinary rates Taxed at ordinary rates Some interest taxed at favorable rates or exempt Some interest taxed at favorable rates or exempt Some dividends taxed at favorable rates or exempt Some capital gains taxed favorably or exempt Taxed at ordinary rates Some dividends taxed at favorable rates or exempt Taxed at ordinary rates Some capital gains taxed favorably or exempt Some capital gains taxed favorably or exempt Taxed at ordinary rates Some capital gains taxed favorably or exempt Reference: Level III Curriculum, Volume 2, Reading Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 2.4 Other Considerations Some countries permit TDA that: Defer taxation on investment returns May permit a deduction for contributions May occasionally permit tax-free distributions AFTER-TAX ACCUMULATIONS AND RETURNS FOR TAXABLE ACCOUNTS 3.1 Simple Tax Environments 3.1.1 Return Based Taxes: Accrual Taxes on Interest and Dividend Accrual taxes ⇒ levied & paid on a periodic basis, usually annually ܨܫܸܨ = ൫1 + ݎሺ1 − ݐ ሻ൯ Where ܨܫܸܨ = Future value interest factor after investment tax r = before tax return ݐ = tax on investment income n = no of periods Tax drag $ = returns without tax - returns with tax ܶܽ݃ܽݎ݀ ݔ% = ்௫ ௗ $ ்௧ ௧௨ ௧௫ Important considerations: Tax drag > tax rate Tax drag $ & % has a direct relation with investment horizon & investment return 3.1.2 Returns-Based Taxes: Deferred Capital Gains Tax on an investment’s returns is deferred until the end of investment horizon ܨܫܸܨீ = ሾሺ1 + ݎሻ ሺ1 − ݐீ ሻሿ + ݐீ 2nd term-returns the tax associated with the initial investment Important consideration: Tax drag% = tax rate Value of a capital gain tax deferral has a direct relation with investment return & time horizon 3.1.3 Cost Basis Cost basis ⇒ amount that was paid to acquire an asset Cost basis has inverse relation with taxable gains ܨܫܸܨீ = ሾሺ1 + ݎሻ ሺ1 − ݐீ ሻሿ + ሺݐீ × ܤሻ Lower the base, lower the future accumulation 3.1.4 Wealth-Based Taxes Wealth tax rate tends to be much lower than income tax rates (applied to the entire capital base) ܨܫܸܨ௪ = ሾሺ1 + ݎሻሺ1 − ݐ௪ ሻሿ Important consideration: Tax drag > tax rate Tax drag as returns Tax drag as investment horizon Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 3.2 Blended Taxing Environments Investment returns may simultaneously include interest, dividend, realized & unrealized capital gains Realized tax rate ⇒ applicable to interest, dividend & realized capital gains Realized tax rate = ሺܲ ݐ ሻ + ሺܲௗ ݐௗ ሻ + ሺܲீ ݐீ ሻ ܴோ் = ܴ ௧௫ ሺ1 − ݁ݐܽݎ ݔܽݐ ݀݁ݖ݈݅ܽ݁ݎሻ To incorporate deferred capital gain taxes: ܶாீ = ܶீ ቂ ሺଵି ି ିಸሻ ቃ ଵିோ௭ௗ ௧௫ ௧ ܨܫܸܨ௧௫ = ሺ1 + ܴோ் ሻே ሺ1 − ܶாீ ሻ + ܶாீ − ሺ1 − ܤሻܶீ 3.3 Accrual Equivalent Returns and Tax Rates Accrual equivalent after-tax return ⇒ tax free return that produces the same after tax accumulations as the taxable portfolio Tax drag = taxable return – accrual equivalent return 3.3.1 Calculating Accrual Equivalent Returns ி ܴா = ቂ ቃ ଵൗ ே −1 Incorporates the impact of deferred taxes on realized gains as well as taxes that accrue annually RAE approaches to pretax return as: Time horizon increases More returns are deferred 3.3.2 Calculating Accrual Equivalent Tax Rates ܶா = − ோಲಶ ோ್ೝ ೌೣ ܶா can be used to measure the tax efficiency of different asset classes or management styles Can be used to assess the impact of future tax law changes TYPES OF INVESTMENT ACCOUNTS Future accumulation depends heavily on the type of account in which assets are held Most of investment accounts can be classified into three categories: Taxable accounts Front-end loaded tax benefits or tax deferred accounts Back-end loaded tax benefits or tax exempt accounts Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 4.1 Tax-Deferred Accounts ்ܨܫܸܨ = ሺ1 + ݎሻ ሺ1 − ܶ ሻ Assets held in a TDA accumulate on a taxdeferred basis, assuming cost basis equal to zero 4.2 Tax-Exempt Accounts ்ܨܫܸܨ௫ ா = ሺ1 + ݎሻே Contributions are made after tax Difference with TDA: The taxing authority owns ܶ of the principal value of a TDA Assets in TDA have built in tax liability 4.3 After-Tax Asset Allocation Allocation on an after-tax basis can be difficult because: After-tax value is time horizon dependent which is difficult to estimate & may ∆ over time Improving client awareness on after tax basis can be challenging 4.4 Choosing Among Account Types Contributions to TDAs are tax deductible whereas contributions to tax exempt accounts generally are not If ܶ > ܶthen value of TDA < value of tax exempt account & vice versa Where ܶ is applicable to tax exempt account at time TAXES AND INVESTMENT RISK If investment returns are subject to tax, govt shares risk & return with the investor SD of after tax return for a taxable account is: ܵܦ௧௫ ሺ1 − ݐ ሻ IMPLICATIONS FOR WEALTH MANAGEMENT Tax alpha ⇒ value created (tax savings) by using investment techniques Copyright © FinQuiz.com All rights reserved 2018 Study Session # 4, Reading # 6.1 Assets Location A well-designed portfolio prescribes a proper asset allocation & asset location Company should place heavily taxed assets within the pension fund & locate more lightly taxed securities outside the fund Place tax-free municipal bonds in a taxable accounts & more heavily taxed stocks in a TDA 6.2 Trading Behavior Trader Active Investor Trades frequently Accumulates the least amount of wealth Recognizes all portfolio returns in the form of annually taxed short term gains Trades less frequently Longer term gains & more favorable tax treatment Passive Investor Exempt Investor Passively buys & holds stocks More accumulation than active investors No capital gains tax liability Accumulates the highest amount of wealth Follow buy & hold strategy 6.3 Tax Loss Harvesting Tax loss harvesting ⇒ process of reducing the current year’s tax obligation through realizing a loss to offset a gain May be subject to limitations At a minimum, tax loss harvesting in current period can create time value of money through reinvestment of tax savings HIFO ⇒ sell the highest cost basis lots first Suitable when tax rates are expected to LIFO ⇒ liquidate low basis stock first Suitable if current tax rate is temporarily low 6.4 Holding Period Management Strategies to reduce taxes by varying the holding period depending on the magnitude of gain from waiting Usually ݁ݐܽݎ ݔܽݐ௦௧ ௧ > ݁ݐܽݎ ݔܽݐ ௧ , in order to produce same after tax results ݃ܽ݅݊ݏ௦௧ ௧ must be >݃ܽ݅݊ݏ ௧ 6.5 After-Tax Mean-Variance Optimization In developing an after-tax MVO model consider: Accrual equivalent return instead of pretax return After-tax SD instead of pretax SD Optimization process must include some constraints (e.g limited amount to TDA account) Copyright © FinQuiz.com All rights reserved ... drag as returns Tax drag as investment horizon Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 4, Reading # 3. 2 Blended Taxing Environments Investment returns may simultaneously.. .20 18 Study Session # 4, Reading # 2. 4 Other Considerations Some countries permit TDA that: Defer taxation on investment... accounts Back-end loaded tax benefits or tax exempt accounts Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 4, Reading # 4.1 Tax-Deferred Accounts ்ܨܫܸܨ = ሺ1 + ݎሻ ሺ1 − ܶ
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