CFA 2018 r09 taxes and private wealth management in a global context slides

After-Tax Accumulations and Returns for Taxable Accounts Returns-Based Taxes: Accrual Taxes on Interest and Dividends... What portion of investment gains consumed by taxes?.2. www.ift.wo

Level III

Taxes and Private Wealth Management in a Global Context

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Reproduced and republished with permission from CFA Institute All rights reserved

Contents

1 Introduction

2 Overview of Global Income Tax Structures

3 After-Tax Accumulations and Returns For Taxable Accounts

4 Types of Investment Accounts

5 Taxes and Investment Risk

6 Implications for Wealth Management

1 Introduction

• Learn basic concepts which serve as foundation for building

tax-aware investment models

• Develop framework with which advisers can communicate

impact of taxes on portfolio returns

2 Overview of Global Income Tax Structure

Taxes on Income Wealth-Based Taxes Taxes on Consumption

2.1 International Comparisons of Income Taxation

2.2 Common Elements

2.3 General Income Tax Regimes

2.4 Other Considerations

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Ordinary income

Investment income often taxed differently based on the nature of the income:

Interest, dividends, capital gains

1 Common Progressive Regime

2 Heavy Dividend Tax Regime

3 Heavy Capital Gain Tax Regime

4 Heavy Interest Tax Regime

5 Light Capital Gain Tax Regime

6 Flat and Light Regime

7 Flat and Heavy Regime

Example 1 Progressive Tax Rate Structure

3 After-Tax Accumulations and Returns for Taxable Accounts

Returns-Based Taxes: Accrual Taxes on Interest and Dividends

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Example 2 Flat Tax Rate = 20% 7% return over 20 years Initial portfolio 100,000

1 Expected wealth after 20 years?

2 What portion of investment gains consumed by taxes?

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Returns-Based Taxes: Deferred Capital Gains

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Example 3 Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years

1 What is the expected wealth at the end of 20 years?

2 What portion of investment gain consumed by taxes?

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Cost Basis

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Example 4 Current market value = 100,000 Cost basis = 80,000 7% and 20 years

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Wealth-Based Taxes

Example 5 Wealth tax of 1.0% on final assets each year Portfolio of 400,000 is expected to return 6%

for the next 10 years

1 Expected wealth at end of 10 years?

2 Proportion of investment gains consumed by taxes?

3.2 Blended Taxing Environments

Different taxing schemes can be integrated into a single framework

Consider portion of investment return from interest, dividend and capital gain

Example 6 Portfolio = 100,000 Grows to 108,000 by year end Interest = 400, Dividend = 2,000 CG = 3,600

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Example 7 Portfolio = 100,000 Grows to 108,000 by year end Interest = 400, Dividend = 2,000 CG = 3,600

Dividend and realized capital gains taxed at 15% Interest taxed at 35%

1 What is the annual return after realized taxes?

2 What is the balance at the end of the year after taxes are paid?

Annual return after realized taxes

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Future Long Term Accumulation

In the previous example we did not consider of deferred capital gains taxes

If we do, the effective capital gains tax rate is:

Future after-tax accumulation:

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Example 8: Future Long Term Accumulation

Portfolio = 100,000 8% gain 5-year horizon Interest = 400, Dividend = 2,000 CG = 3,600

Dividend and realized capital gains taxed at 15% Interest taxed at 35%

Look at Exhibit 5

3.3 Accrual Equivalent Returns and Tax Rates

Accrual equivalent after-tax return is the tax-free return that if accrued annually produces the same after-tax accumulation as the taxable portfolio

Say 100  121 in 2 years after taxes

Accrual equivalent return is 10%

Embedded example: 100  138.66 in 5 years after taxes What is accrual equivalent return?

Accrual Equivalent Tax Rates

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Example 9 Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years

1 What is the accrual equivalent return?

2 What is the accrual equivalent tax rate?

4 Types of Investment Accounts

Taxable Accounts

Invest after-tax money

Profits/returns are taxed (as discussed in section 3)

Tax Deferred Accounts (TDA)

IRA

Tax Exempt Accounts

Roth IRA

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Example 10 100,000 for 20 years 7% return Tax = 20% Compute after-tax wealth after 20 years:

1 Taxable account, taxed annually

2 Taxable account Deferred capital gains tax

3 Tax deferred account

4 Tax exempt account

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4.3 After-Tax Asset Allocation

Stocks worth 1.5 million in TDA

Bonds worth 0.5 million in TEA

What are weights?

Need to consider after tax weights

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4.4 Choosing Among Account Types

TDE seems better than TDA but…

1 Contributions to TDA are tax deductible

2 Investors tax rate might be lower upon withdrawal

Example 11

5 Taxes and Investment Risk

For assets in taxable accounts:

Taxing authority shares investment risk with investor

Hence, taxes can reduce investment risk

For assets in TDAs and TEAs:

Investor bears all risk associated with returns

See Exhibit 7 if you want to be super diligent

6 Implications for Wealth Management

6.1 Asset Location

6.2 Trading Behavior

6.3 Tax Loss Harvesting

6.4 Holding Period Management

6.5 After-Tax Mean-Variance Optimization

Techniques for effectively managing tax liabilities  Tax Alpha

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6.1 Asset Location

Three types of accounts: 1) Taxable 2) TDA and 3) Tax Exempt

Choice of where to place specific assets is called the asset location decision

TDAs and Tax-Exempt

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6.2 Trading Behavior

If tax on short term gains > tax on long term gains  Reduce short-term trading

Active managers must earn greater pre-tax alphas than passive managers to offset tax drag of

active trading

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6.3 Tax Loss Harvesting

Realize loss to offset gain  Tax Loss Harvesting Example 12 Current Tax Saving

Tax saving realized in a given year from tax loss harvesting overstates the true gain

Selling security at a loss resets costs basis (B) to a lower level  higher future tax liability

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6.4 Holding Period Management

Many tax regimes encourage longer term investments

Example 15

6.5 After-Tax Mean-Variance Optimization

Traditional mean-variance optimization can be modified to accommodate after-tax risk and return Evaluate based on accrual equivalent returns

Consider optimal asset location

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Review learning objectives

Examples

Practice Problems