Reading 9 Taxes and Private Wealth Management in a Global Context

Question 1

Why most modern portfolio theory is grounded in a pretax framework?

Answer 1

This phenomenon is understandable because most institutional and pension portfolios are tax-exempt

Question 2

three primary categories of taxes

Answer 2

1. Taxes on income

• paid by individuals, corporations, and other legal entities on various types of income including wages, interest, dividends, and capital gains.

2. Wealth-based taxes

• paid on the value of assets held and on wealth transfers.

3. Taxes on consumption

• sales taxes: paid by consumer
• value-added taxes: paid at each intermediate production step according to the amount of value added at the step; ultimately borne be the consumer (added into the purchase price)

Question 3

marginal tax rate, definition

Answer 3

the tax rate paid on the very last (highest) dollar of income

Question 4

Seven global tax regimes

Answer 4

Question 5

Common Progressive Income Tax Regime

Answer 5

• Ordinary Tax Rate Structure: Progressive
• Interest Income: Some interest taxed at favorable rates or exempt
• Dividends: Some dividends taxed at favorable rates or exempt
• Capital Gains: Some capital gains taxed favorably or exempt

Question 6

Heavy Dividend Tax Regime

Answer 6

• Ordinary Tax Rate Structure: Progressive
• Interest Income: Some interest taxed at favorable rates or exempt
• Dividends: Taxed at ordinary rates
• Capital Gains: Some capital gains taxed favorably or exempt

Question 7

Heavy Capital Gain Tax Regime

Answer 7

• Ordinary Tax Rate Structure: Progressive
• Interest Income: Some interest taxed at favorable rates or exempt
• Dividends: Some dividends taxed at favorable rates or exempt
• Capital Gains: Taxed at ordinary rates

Question 8

Heavy Interest Tax Regime

Answer 8

• Ordinary Tax Rate Structure: Progressive
• Interest Income: Taxed at ordinary rates
• Dividends: Some dividends taxed at favorable rates or exempt
• Capital Gains: Some capital gains taxed favorably or exempt

Question 9

Light Capital Gain Tax Regime

Answer 9

• Ordinary Tax Rate Structure: Progressive
• Interest Income: Taxed at ordinary rates
• Dividends: Taxed at ordinary rates
• Capital Gains: Some capital gains taxed favorably or exempt

Question 10

Flat and Light Regime

Answer 10

• Ordinary Tax Rate Structure: Flat
• Interest Income: Some interest taxed at favorable rates or exempt
• Dividends: Some dividends taxed at favorable rates or exempt
• Capital Gains: Some capital gains taxed favorably or exempt

Question 11

Flat and Heavy Regime

Answer 11

• Ordinary Tax Rate Structure: Flat
• Interest Income: Some interest taxed at favorable rates or exempt
• Dividends: Taxed at ordinary rates
• Capital Gains: Taxed at ordinary rates

Question 12

Accrual Taxes on Interest and Dividends

Answer 12

FVIF_i = [1 + r(1 – t_i)]ⁿ

r - pretax return

t - tax

Three important relationships:

1. Tax drag % > tax rate
2. As investment horizon increases -> tax drag $ and tax drag % increase
3. As investment return increase -> tax drag $ and tax drag % increase

Question 13

Deferred Capital Gains Taxes.

Answer 13

FVIF_cg = (1 + r)ⁿ(1 – t_cg) + t_cg

t_cg - tax on capital gain

Relationships:

1. Tax drag % = tax rate
2. As the investment horizon increases => tax drag is unchanged
3. As the investment return increases => tax drag is unchanged
4. As investment horizon increases => the value of tax deferral increases
5. As the investment return increases => the value of the tax deferral increases

Question 14

Cost basis and its influence on capital gain taxes

Answer 14

In taxation, cost basis is generally the amount that was paid to acquire an asset.

FVIF_cgb = (1 + r)ⁿ(1 – t_cg) + t_cgB

Question 15

Wealth-Based Taxes

Answer 15

FVIF_w = [(1 + r)(1 – t_w)]ⁿ

Wealt-Based Taxes vs. Accrual Taxes:

• as with accrual taxes - tax drag $ and tax drag % increase with investment horizon
• unlike accrual taxes - when investment return increases, tax drag % decreases

Relationships:

1. Tax drag % > Tax rate
2. As investment horizon increases => tax drag % and tax drag $ increase
3. As investmnet return increases => tax drag $ increases; tax drag % decreases

Question 16

Blended Taxing Environments

Answer 16

r* = r(1 – p_it_i – p_dt_d – p_cgt_cg)

T* = t_cg(1 – p_i – p_d – p_cg)/(1 – p_it_i – p_dt_d – p_cgt_cg)

FVIF_Taxable = (1 + r*)ⁿ(1 – T*) + T* – (1 – B)t_cg

Question 17

Accrual Equivalent Returns and Tax Rates

Answer 17

Conceptually, an accrual equivalent after-tax return is the tax-free return that, if accrued annually, produces the same after-tax accumulation as the taxable portfolio.

R_AE = (FV_T/PV)^1/n-1

*the difference between pretax return and the AE after-tax return is a measure of the tax drag on the portfolio

The accrual equivalent tax rate is derived from the accrual equivalent return. It is the hypothetical tax rate, T_AE, that produces an after-tax return equivalent to the accrual equivalent return. In our example, it is found by solving for T_AE in the following expression:

r(1 – T_AE) = R_AE or T_AE = 1-R_AE/R

The accrual equivalent tax rate can be used in several ways:

1. it can be used to measure the tax efficiency of different asset classes or portfolio management styles.
2. it illustrates to clients the tax impact of lengthening the average holding periods of stocks they own.
3. it can be used to assess the impact of future tax law changes.

*the lower the accrual equivalent tax rate, the more tax efficient the investment; likewise, allocating heavily to tax-inefficient assets speeds up tax payments and increases the AE tax rate

• !!! AE tax rate decreases as B increases
• !!! AE tax rate decreases as the investment horizon increases

Question 18

Types of investment accounts

Answer 18

Most types of investment accounts can be classified into three categories:

• Taxable accounts. Investments to these accounts are made on an after-tax basis and returns can be taxed in a variety of ways as discussed in the previous section.
• Tax-deferred accounts, or TDAs. Contributions to these accounts may be made on a pretax basis (i.e., tax-deductible), and the investment returns accumulate on a tax-deferred basis until funds are withdrawn at which time they are taxed at ordinary rates. As such, these accounts are sometimes said to have front-end loaded tax benefits.

FVIF_TDA = (1 + r)ⁿ(1 – T_n)

!!! there is no “+ BTn” here

• A third class of accounts has back-end loaded tax benefits. These accounts can be called tax-exempt (at least on a forward-looking basis) because although contributions are not deductible, earnings accumulate free of taxation even as funds are withdrawn, typically subject to some conditions.

FVIF_TaxEx = (1 + r)ⁿ

! The only potenial difference between accumulations in TDA and TEA accounts depends on whether the current and future tax rates are equal. Any contributions to a tax-exempt account are made with after-tax funds.

! A different result can arise if regulations limit the amount of deposit and the limit is the same for both TDA and TEA accounts. Even if the current and future rates are equal, the TEA can be superior.

Question 19

Tax alpha, definition

Answer 19

The value created by using investment techniques that effectively manage tax liabilities is sometimes called tax alpha

Question 20

Asset location decision

Answer 20

An interaction exists between deciding what assets to own and in which accounts they should be held. The choice of where to place specific assets is called the asset location decision. It is distinct from the asset allocation decision.

Taxes not only reduce an investor’s returns, but also absorb some investment risk

Question 21

Four types of equity investors

Answer 21

1. Traders - due to frequent trading, traders forgo the tax advantages assosiated with equity. All gains are short term and are thus taxed on an annual basis.
2. Active investors - active investors trade less frequently than traders so that many of their gains are longer term in nature and taxed at lower rates.
3. Passive investors - passive investors buy and hold equity so that gains deferred long term and taxed at preferential rates.
4. Exempt investors - exempt investors hold all their stock in tax-exempt accounts, thereby avoiding taxation altogether.

Active managers must earn greater pretax alphas than passive managers to offset the tax drag of active trading

Question 22

Tax Loss Harvesting

Answer 22

While jurisdictions allow realized capital losses to offset realized capital gains, limitations are often placed on the amount of net losses that can be recognized or the type of income it can offset.

The practice of realizing a loss to offset a gain or income—and thereby reducing the current year’s tax obligation—is called tax loss harvesting.

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. The value of tax loss harvesting is largely in deferring the payment of tax liabilities.

A subtle benefit of tax loss harvesting is that recognizing an already incurred loss for tax purposes increases the amount of net-of-tax money available for investment. Realizing a loss saves taxes in the current year, and this tax savings can be reinvested. This technique increases the amount of capital the investor can put to use.

A concept related to tax loss harvesting is using highest-in, first-out (HIFO) tax lot accounting to sell a portion of a position. When positions are accumulated over time, lots are often purchased at different prices. Depending on the tax system, investors may be allowed to sell the highest cost basis lots first, which defers realizing the tax liability associated with lots having a lower cost basis. HIFO allows tax savings to be reinvested earlier, creating a tax alpha that compounds through time.

LIFO, lowest-in/first-out accounting - it could be beneficial for the investor to liquidate a lower cost basis stock and recognize capital gain now

Question 23

Taxes and mean-variance optimization

Answer 23

Pretax efficient frontiers may not be reasonable proxies for after-tax efficient frontiers

Ideally, the efficient frontier should be viewed on ana after-tax basis.

The mean-variance optimization should optimally allocate and determine the optimal asset location for each asset. Accrual equivalent after-tax returns would be sustituted for before-tax returns, and risk on an after-tax basis would be substituted fore before-tax risk.