CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r09 taxes and private wealth management summary

Regime Common Progressive Heavy Dividend Tax Heavy Capital Gain Tax Heavy Interest Tax Light Capital Gain Tax Flat and Light Flat and Heavy Ordinary Tax Rate Structure Progres

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Level III

Taxes and Private Wealth Management

Summary

Regime Common

Progressive

Heavy Dividend Tax

Heavy Capital Gain

Tax

Heavy Interest

Tax

Light Capital Gain Tax

Flat and Light Flat and Heavy

Ordinary

Tax Rate

Structure

Progressive Progressive Progressive Progressive Progressive Flat Flat

Interest

Income

Taxed favorably or exempt

Taxed favorably or exempt

Taxed favorably or

exempt

Taxed at ordinary

rates

Taxed at ordinary

rates

Taxed favorably or exempt

Taxed favorably

or exempt

Dividends

Taxed favorably or exempt

Taxed at ordinary rates

Taxed favorably or

exempt

Taxed favorably

or exempt

Taxed at ordinary

rates

Taxed favorably or exempt

Taxed at ordinary (flat) rates

Capital

Gains

Taxed favorably or exempt

Taxed favorably or exempt

Taxed at ordinary

rates

Taxed favorably

or exempt

Taxed favorably

or exempt

Taxed favorably or exempt

Taxed at ordinary (flat) rates

Basic Global Taxation Regimes

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Impact of Taxes on Future Wealth

Returns-based taxes:

accrual taxes on interest

and dividends

FVIF i = [1 + r(1 – t i)]n Amount = 100, r = 7%, n = 20 years and t = 20%:

FV = 100 × [1 + 0.07(1 – 0.20)] 20 = 297 Without taxes, FV = 387 Difference = 90 Tax impact = 90 / 287 = 31% which is > 20%

Returns-based taxes:

deferred capital gains

FVIF cgb = (1 + r) n (1 – t cg ) + t cg B Scenario 1: Amount = 100, cost basis = 100,

r = 7%, n = 20 years and t = 20%

FV = 100 × [(1 + 0.07) 20 (1 – 0.20) + 0.20] = 330 > 297

Scenario 2: Amount = 100, cost basis = 80,

r = 7%, n = 20 years and t = 20%

FV = 100 × [(1 + 0.07) 20 (1 – 0.20) + 0.20(0.80)] = 326

Wealth-based taxes FVIF w = [(1 + r)(1 – t w)]n Amount = 400, r = 6%, n = 10 years and t = 1%:

400*(1.06)(1 − 0.01)+ 10 = 648, or gain = 248 Without tax: 400 x 1.06 10 = 716, gain 316 (316 – 248) / 316 = 21.5%

A 1% wealth tax consumed 21.5% of the gain

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Impact of Investment Return and Time Horizon on Taxes

When investment returns are subject to accrued taxes on annual basis:

 Tax drag > nominal tax rate

 All else equal, as investment horizon increases  tax drag increases

 All else equal, as investment return increases  tax drag increases

 Given investment returns, the longer the time horizon, the greater the tax drag

 Given investment time horizon, the higher the investment returns, the greater

the tax drag

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Blended Tax Environment

Formula / Example

Annual return after realized

taxes

r* = r (1 – p i t i – p d t d – p cg t cg)

r* = 8%[1 – (0.05 × 0.35) – (0.25 × 0.15) – (0.45 × 0.15)] = 7.02%

Effective capital gains tax rate

(recognizes that income and

realized capital gains have been

taxed)

T* = t cg (1 – p i – p d – p cg )/(1 – p i t i – p d t d – p cg t cg)

= 0.15*(1 − 0.05 − 0.25 − 0.45)/(1 − 0.05 × 0.35 − 0.25 × 0.15 − 0.45 × 0.15)] = 0.15(0.25/0.8775) = 4.27%

Future after-tax accumulation

for each unit of currency in a

taxable portfolio

FVIF Taxable = (1 + r*) n (1 – T*) + T* – (1 – B)t cg  

100 [(1.0702) 5 (1 − 0.0427) + 0.0427 − (1 − 1.00)0.15+ = 139

Accrual-equivalent return

Accrual-equivalent tax rate

If we start with 100 and end with an after-tax amount of 139 after 5

r(1 – T AE ) = R AE

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Investment Accounts – Tax Profiles

Taxable Account Contributions are after-tax

Returns are taxed

Discussed previously

Tax-Deferred

Accounts (TDAs)

Contribution are pre-tax

Returns accumulate on tax-deferred basis until

funds are withdrawn; taxed at ordinary rates

Tax-Exempt

Accounts

Contributions are after-tax Returns are not taxed

𝐅𝐕𝐈𝐅𝐓𝐚𝐱𝐄𝐱 = 𝟏 + 𝒓 𝒏

• If future taxes are expected to be lower than current taxes  tax-deferred accounts are better

• If future taxes are expected to be higher than current taxes  tax-exempt accounts are better

• Tax alpha: value generated by using techniques that effectively manage tax liabilities

• Asset location decision: choice of where to place the specific assets

 Heavily-taxed assets should be held in tax-sheltered accounts

 Lightly-taxed asset should be held in taxable accounts

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Taxes and Investment Risk

• For assets in taxable accounts, taxes reduce both investment

risk and return

• For assets in TDA’s and tax exempt accounts, investor bear all

risk associated with returns

Investors after-tax risk = σ (1 - T)

After-tax Returns and Trading Behavior

• Many tax regimes encourage longer term investments

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

• Active managers must earn greater pre-tax returns than passive managers to offset

tax drag of active trading

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Tax Loss Harvesting, HIFO and MVO

Tax loss harvesting: realizing capital losses to offset taxable gains in that tax

year  decrease in the current year’s tax liability

Best used when tax rates are relatively high

Highest-in, first-out (HIFO): highest cost basis lots are sold first to defer the tax

on the low cost basis lots, resulting in decrease in current capital gain taxes

Reinvesting current year’s tax savings increases the after-tax principal

investment

This strategy postpones the payment of taxes

Deferring taxes may not be a desirable strategy if tax rates are expected to increase

• Traditional mean-variance optimization should be modified to accommodate after-tax risk and return

• Mean variance optimization algorithm should use after-tax standard deviations of returns and accrual

equivalent returns rather than pretax standard deviations and pretax returns

• An after-tax portfolio optimization model that optimizes asset allocation also optimizes asset location