Reading 29: Taxes & Private Wealth Management in a Global Context Flashcards
Taxable Accounts
The taxable account will have the lowest risk because the government (taxing authority) effectively shares the risk of the investment with the investor. Assuming before-tax standard deviation of σ, the after-tax standard deviation of the investment is σ(1 − TI). In a tax-exempt account, the variability of returns is not affected by the taxes and the investor bears all the investment risk.
Types of Investors Tax Effect
The trader will have the lowest future accumulation because her capital gains will be short term, taxed at a high rate, and taxed every year. The active investor will have the next lowest future accumulation because, although gains are taxed at a lower rate, the gains are taxed every year. The passive investor will pay a low tax rate on a deferred basis and have the highest accumulations of the three investors (taxed at the end of the investment horizon as they are buy and hold).
Tax Loss Harvesting
Although a strategy of selling at a loss this year to reduce taxes and selling at the end of next year (assuming same price appreciation) to realise the loss at the end of next year may seem like they give the same return, selling at a loss now allows the investor to invest that tax loss savings to gain the price appreciation, making that strategy the best.
Average Vs Marginal Tax Rate
Average tax rate is taxes paid over taxable income. Marginal tax rate is the highest tax rate bracket. Progressive tax rates increase as income increases.
Seven Global Tax Regimes
Common Progressive (most common): progressive and favourable treatment of interest, dividends, and capital gains. Heavy Dividend Tax: progressive with favourable tax on capital gains and interest but not dividends. Heavy Capital Gain Tax: progressive with favour on interest and dividends but not capital gains. Heavy Interest Tax: progressive favouring dividend and capital gains but not interest. Flat & Light: flat base tax rate favouring interest, dividends, and capital gains. Flat & Heavy: flat rate favouring interest and capital gains but not dividends.
Accrual Taxes
Paid periodically. As time horizon increases, tax drag percentage exceeds tax rate as taxes reduce benefits on compounding. Higher rates of return also increase the tag drag.
Deferred Capital Gain Tax
There is no lost compounding however tag drag will still increase with longer horizons and higher returns as tax will be on a larger pretax ending value. If there is no initial unrealised gain or loss (basis), tax drag percentage will equal the tax rate. If B is greater than one tax drag percentage will be lower than tax rate as there is an initial unrealised loss, if B is below one tax drag will be greater than the tax rate.
Wealth Tax
Usually taxed at lower rates but is taxed on the total value not just return. Adverse effects increase as time horizon increases (both tax drag amount and percentage). Higher rates of return cause tax drag amount to increase but percentage to decrease. Tax drag percentage is minimised at moderate time horizon and return.
Tax Deferred Account Vs Tax Exempt Accounts
The tax is paid at the end with TDA and at the beginning with TEA. If the tax rate now and the tax rate in the future are the same, then both will have the same return. If the tax rate now is lower, use the TEA. If the tax rate in the future is lower use the TDA. There can be limits placed on how much can go in a TDA or TEA which can cause this relationship to change.
Tax Alpha
This involves allocation of securities to appropriate tax efficient account. Typically bonds will be held in tax deferred account while equities will be held in taxable accounts as capital gains tax is deferred anyway, and dividends are usually low compared to capital gains. Leverage can also be used to increase an allocation in line with targets instead of taking funds out of a tax advantageous account to rebalance, this optimises tax alpha.
Notes
Asset allocation is more important than asset location. Borrowing to optimise tax alpha and asset allocation is an unusual strategy. More frequent trading may reduce after tax returns.
Tax Loss Harvesting
Realising losses to offset other taxable income. When the tax loss is harvested, the proceeds are usually reinvested and the reinvested proceeds become a new lower cost basis (they then have a higher realised gain when sold which amount to less tax shelter in future). However re-investing the proceeds tends to increase returns.
Highest In / First Out (HIFO)
When investors make a sale and purchased the security at different costs on different dates, some authorities allow them to choose which cost basis they want to use. Typically use highest cost price (HIFO) but if future taxes are projected to increase use the lower cost price now to utilise the high cost price later (LIFO).
Mean Variance Optimisation
Ideally the efficient frontier should be viewed on an after tax basis. Accrual equivalent after tax returns and risk on an after tax basis would be used for mean-variance optimisation.
