Taxes on Consumption 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.. 2.1 Internat
Trang 1“ TAXES AND PRIVATE WEALTH MANAGEMENT
2 OVERVIEW OF GLOBAL INCOME TAXSTRUCTURES
Taxes on the holding of certain types of property
Wealth transfer taxes
TDA = Tax Deferred Accounts
SD = Standard Deviation
Sources of Govt Tax Revenue
Wealth-Based Taxes
Taxes on ordinary &
investment income
Taxes on Income
Sales tax
Value added taxes
Taxes on Consumption
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
2.1 International Comparisons of Income Taxation
2.2 Common Elements
Classification of Income Tax Regime
Progressive
2 – Heavy Dividend Tax
3 – Heavy Capital Gain Tax
4- Heavy Interest Tax
5 – Light Capital Gain Tax
6 – Flat and Light 7 - Flat and Heavy
Ordinary Tax
Rate Structure
Progressive Progressive Progressive Progressive Progressive Flat Flat
Interest
Income
Some interest taxed at favorable rates
or exempt
Some interest taxed at favorable rates
or exempt
Some interest taxed at favorable rates
or exempt
Taxed at ordinary rates
Taxed at ordinary rates
Some interest taxed
at favorable rates
or exempt
Some interest taxed
at favorable rates or exempt
Dividends Some dividends
taxed at favorable rates
or exempt
Taxed at ordinary rates
Some dividends taxed at favorable rates
or exempt
Some dividends taxed at favorable rates
or exempt
Taxed at ordinary rates
Some dividends taxed at favorable rates or exempt
Taxed at ordinary rates
Capital Gains 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
Some capital gains taxed favorably or exempt
Some capital gains taxed favorably or exempt
Taxed at ordinary rates
2.3 General Income Tax Regimes
Reference: Level III Curriculum, Volume 2, Reading 9
Trang 2Some countries permit TDA that:
Defer taxation on investment returns
May permit a deduction for contributions
May occasionally permit tax-free distributions
2.4 Other Considerations
Accrual taxes ⇒ levied & paid on a periodic basis, usually annually
= 1 + 1 −
Where
= Future value interest factor after investment tax
r = before tax return
= tax on investment income
n = no of periods
Tax drag $ = returns without tax - returns with tax
Important considerations:
Tax drag > tax rate
Tax drag $ & % has a direct relation with investment horizon & investment return
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
Tax on an investment’s returns is deferred until the end of investment horizon
= 1 + 1 − +
2nd term-returns 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
3.1.2 Returns-Based Taxes: Deferred Capital Gains
Cost basis ⇒ amount that was paid to acquire an asset
Cost basis has inverse relation with taxable gains
= 1 + 1 − + ×
Lower the base, lower the future accumulation
3.1.3 Cost Basis
Wealth tax rate tends to be much lower than income tax rates (applied to the entire capital base)
= 1 + 1 −
Important consideration:
Tax drag > tax rate
Tax drag as returns
Tax drag as investment horizon
3.1.4 Wealth-Based Taxes
Trang 3Investment returns may simultaneously include interest, dividend, realized &
unrealized capital gains
Realized tax rate ⇒ applicable to interest, dividend & realized capital gains
Realized tax rate = + +
=
To incorporate deferred capital gain taxes:
=
= 1 + 1 − + −1 −
3.2 Blended Taxing Environments
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 Accrual Equivalent Returns and Tax Rates
=
!
− 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
3.3.1 Calculating Accrual Equivalent Returns
= 1 −
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
3.3.2 Calculating Accrual Equivalent Tax Rates
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
4 TYPES OF INVESTMENT ACCOUNTS
Trang 4"= 1 + 1 −
Assets held in a TDA accumulate on a tax-deferred basis, assuming cost basis equal to zero
4.1 Tax-Deferred Accounts
#= 1 +
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
4.2 Tax-Exempt Accounts
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
4.3 After-Tax Asset Allocation
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
4.4 Choosing Among Account Types
1 −
If investment returns are subject to tax, govt shares risk & return with the investor
SD of after tax return for a taxable account is:
5 TAXES AND INVESTMENT RISK
Tax alpha ⇒ value created (tax savings) by using investment techniques
6 IMPLICATIONS FOR WEALTH MANAGEMENT
Trang 5A 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
6.1 Assets Location
6.2 Trading Behavior
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
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 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
Usually > , in order to produce same after tax results
must be >
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)
6.5 After-Tax Mean-Variance Optimization