FinQuiz smart summary, taxes and private weath management in a global context

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2013, Study Session # 4, Reading # 11

“TAXES AND PRIVATE WEALTH MANAGEMENT
IN A GLOBAL CONTEXT”
TDA = Tax Deferred Accounts

LIFO = Lowest in, First Out

HIFO = Highest in, First Out

2. OVERVIEW OF GLOBAL INCOME TAX STRUCTURES

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.

2.1International 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

2 – Heavy
Dividend Tax

Progressive

3 – Heavy
Capital Gain Tax
Progressive

4- Heavy
Interest Tax
Progressive

5 – Light Capital
Gain Tax
Progressive

6 – Flat and Light

7 - 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 11, Page 236-237

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2013, Study Session # 4, Reading # 11

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.

3. 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.

ܶܽ‫݃ܽݎ݀ݔ‬% =

்௔௫ௗ௥௔௚
்௢௧௔௟௥௘௧௨௥௡௕௘௙௢௥௘௧௔௫

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 investment horizon.
‫ܨܫܸܨ‬஼ீ = ሾሺ1 + ‫ݎ‬ሻ௡ ሺ1 − ‫ݐ‬஼ீ ሻሿ + ‫ݐ‬஼ீ
2nd term return 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.
‫ܨܫܸܨ‬஼ீ஻ = ሾሺ1 + ‫ݎ‬ሻ௡ ሺ1 − ‫ݐ‬஼ீ ሻሿ + ሺ‫ݐ‬஼ீ × ‫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 entire capital base).
‫ܨܫܸܨ‬௪ = ሾሺ1 + ‫ݎ‬ሻሺ1 − ‫ݐ‬௪ ሻሿ௡
Important consideration:
Tax drag > tax rate.
Tax drag as returns .
Tax drag as investment horizon .

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2013, Study Session # 4, Reading # 11

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௜ ሻሺܲௗ ‫ݐ‬ௗ ሻሺܲ஼ீ ‫ݐ‬஼ீ ሻ
ܴ஺ோ் = ܴ௕௘௙௢௥௘௧௔௫ ሺ1 − ‫݁ݐܽݎݔܽݐ݀݁ݖ݈݅ܽ݁ݎ‬ሻ
To incorporate deferred capital gain taxes:

ܶா஼ீ = ܶ஼ீ ቂ

ሺଵି௉೔ ି௉೏ ି௉಴ಸሻ

ቃ

ଵିோ௘௔௟௜௭௘ௗ௧௔௫௥௔௧௘
‫ܨܫܸܨ‬௧௔௫௔௕௟௘ = ሺ1 + ܴ஺ோ் ሻே ሺ1 −

ܶா஼ீ ሻ + ܶா஼ீ − ሺ1 − ‫ܤ‬ሻܶ஼ீ

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

ܶ஺ா = 1 −

ோ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.

4. 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.

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2013, Study Session # 4, Reading # 11

4.1 Tax-Deferred Accounts

‫்ܨܫܸܨ‬஽஺ = ሺ1 + ‫ݎ‬ሻ௡ ሺ1 − ܶ௡ ሻ
Assets held in a TDA accumulate on tax-deferred
basis assuming cost basis equal to zero.

4.2 Tax-Exempt Accounts

‫்ܨܫܸܨ‬௔௫ா௑ = 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 0.

5. 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:
ܵ‫ܦ‬௣௥௘௧௔௫ ሺ1 − ‫ݐ‬௜ ሻ

6. IMPLICATIONS FOR WEALTH MANAGEMENT

Tax alpha ⇒ value created (tax savings) by using
investment techniques.

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2013, Study Session # 4, Reading # 11

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 a 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.
Usually‫݁ݐܽݎݔܽݐ‬௦௛௢௥௧௧௘௥௠ > ‫݁ݐܽݎݔܽݐ‬௟௢௡௚௧௘௥௠ , in order to produce same after tax results
݃ܽ݅݊‫ݏ‬௦௛௢௥௧௧௘௥௠ 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).

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