3. Investment Planning. 16. Tax Efficient Investing Flashcards
In many portfolios, 40% of investors’ returns are eroded by taxes. This is mainly due to inefficient investing. Investors need to make decisions that will help defer, minimize, and manage taxes. This requires planning for tax-efficient investments.
The tax system cannot be avoided, but taxes can be managed in order to earn greater after-tax revenues. The current long-term capital gain tax rate is 20% for filers in the 37% marginal bracket 15% for filers in the 22% to 35% marginal bracket, and 0% for filers who fall in the 10% or 12% bracket. The marginal rates now range from 10% to 37% with brackets in between at 12%, 22%, 24%, 32% and 35%. Tax planning is considered an important component of investment management for all investors, particularly affluent investors. However, tax-efficient investing does not apply to individual retirement accounts or other retirement money. It is more relevant for those in the middle or upper tax brackets of at least 28%. In fact, for affluent investors or high-income taxpayers, the tax rates will remain as high as 37% in 2018. An additional 3.8% Medicare tax is attached to capital gains for investors above a certain threshold
The Tax-efficient Investing module, which should take approximately three hours to complete, will explain the various techniques of investing with reduction of tax expenses in mind.
Upon completion of this module you should be able to:
* Identify and contrast different tax investment models,
* Identify tax sensitive investment strategies, and
* Discuss the tax related advantages.
PRACTICE STANDARD 200-1
Determining a Client’s Personal and Financial Goals, Needs and Priorities
The financial planning practitioner and the client shall mutually define the client’s personal and financial goals, needs and priorities that are relevant to the scope of the engagement before any recommendation is made and/or implemented.
AUDIO
There are many investment strategies to help reduce the impact of taxes on investments, and some strategies also seek to minimize the federal and state taxes that significantly diminish real returns.
Taxes and inflation have a significant impact on investment decisions and results. Before investing, your client needs to set his or her goals and decide how much to invest in order to meet those goals. You will need to keep in mind that taxes are certain and relevant and will eat away at investment returns. Thus, you will need to help your clients factor taxes into investments in such a way that the after-tax basis is maximized.
To ensure that you have a solid understanding of tax efficient investing, the following topics will be covered in this module:
* Tax Investment Models
* Tax Investment Strategies
* Tax-Advantaged Accounts
Audio:
Taxes play a big role in investment returns.
* Take advantage of tax-deferred growth as early as possible.
* Investing in tax advantaged accounts.
* Investing in tax managed funds or other funds with lower turnover rates.
* Investing in tax exempt securities
* Offsetting capital gains with losses
Section 1 – Tax Investment Models
This lesson is derived from what has become known as the Scholes-Wolfson approach to investment strategy. The Scholes-Wolfson approach tends to overlook the fact that differences in explicit tax rates will, due to market competition, lead to implicit taxes. These differences are between pre-tax returns on fully taxed investments and the pre-tax returns on partially or tax-exempt investments. Thus, a taxpayer can take advantage of preferential tax provisions to lower his explicit tax burden. When market frictions are low or absent, this differential tax treatment gives rise to differences in pre-tax returns across investments, defined as an implicit tax.
This lesson introduces a conceptual framework for understanding how taxes affect basic investment decisions, without detailing the underlying tax laws. Different models are used to develop and illustrate the after-tax outcomes of various investment alternatives. These models in their basic form reflect the following assumptions:
* The investment’s before-tax rate of return is constant over the investment period.
* The investor’s marginal tax rate is constant over the investment period.
* Investment earnings are reinvested at the same rate of return as earned by the original investment.
* The investor knows future rates of returns and tax rates with certainty.
* The investor incurs no transaction costs.
The models can be modified, however, to accommodate changes to these assumptions.
All investment earnings are taxed. Depending on how investment earnings are taxed, the investment models can be categorized as the Current Model-investment earnings are taxed currently; Deferred Model-investment earnings are taxed at the end of the investment period; Exempt Model-investment earnings are exempt from explicit taxation; Pension Model-the initial investment is deducted or excluded from gross income, and investment earnings are taxed at the end of the investment period.
To ensure that you have a solid understanding of the tax investment models, the following topics will be covered in this lesson:
* Current Model
* Deferred Model
* Exempt Model
* Pension Model
* Multi-period Strategies
Upon completion of this lesson, you should be able to:
* Outline the various investment models,
* Identify examples to build on the investment model, and
* Contrast the various investment models against each other.
TEST TIP
The models and formulas presented in this lesson expand on some of the return measurements discussed in other modules of this course. These models serve as the basis for selection of tax investment strategies, but they are not significant for the CFP Certification Exam. It helps to understand the components of the models and how the manipulation of certain variables changes the focus of the after-tax returns.
If Carlos invested $3,250 for 5 years at a rate of return of 6% and his marginal tax bracket is 35%, what would his accumulation be after taxes?
* $3,935.15
* $4,225.00
* $6,691.13
* $4,797.47
$3,935.15
Here is how to solve the question algebraically:
3250 [1 + (0.06 x 0.65)]^5
3250 [1 + (0.039)]^5
3250 [1.039]^5
3250 [1.2108]
3935.1483
That said, there is actually a much easier method to solve this question! Here is how to solve using Time Value of Money (TVM):
6 x 0.65 = 3.90 I/YR
5 N
3250 +/- PV
Solve FV 3935.1483
Describe the Deferred Model
The Deferred Model gives the future value of an investment having the following characteristics:
* Only after-tax dollars are invested (as with the Current Model).
* The earnings on the investment are not taxed annually, thus they grow at the BTROR.
* The accumulated earnings are taxed at the end of the investment horizon when the investor cashes out of the investment, thus taxation of these earnings is deferred.
The traditional non-deductible IRA is a classic example of the Deferred Model. In this case, if the taxpayer or the taxpayer’s spouse is covered by an employer-sponsored qualified retirement plan and the taxpayer’s AGI exceeds a specified amount, the taxpayer may not deduct contributions to a traditional IRA. Moreover, if the taxpayer’s AGI exceeds another threshold, the taxpayer may not contribute to a Roth IRA. Nevertheless, a taxpayer precluded from making deductible contributions to a traditional IRA or contributions to a Roth IRA still may make non-deductible contributions up to $6,000 per year to a traditional IRA with a catch-up allowance of an additional $1,000 if the owner is over 50 years of age, subject to AGI limits (2022). These non-deductible contributions are after-tax dollars.
We call this model the Deferred Model because the tax on investment earnings is deferred until the investor cashes out of the investment. This characteristic causes the Deferred Model investment to outperform the Current Model investment given equal BTRORs and constant tax rates.
Practitioner Advice: The terminal value of an investment in a taxable account versus the terminal value of a comparable investment in a tax-deferred account can be substantially different. The tax-deferred account will benefit from the extra income available for compounding due to the lack of annual taxation. Thus, it is recommended that people saving for retirement invest in tax-deferred investment vehicles as early as possible.
If Carlos invested before-tax dollars of $5,000 for 5 years at a rate of return of 6%, what would his accumulation be before taxes?
* $5,300.00
* $6,500.00
* $6,083.26
* $6,691.13
$6,691.13
* Carlos’ before tax accumulation would be
* = 5,000(1+.06)^5 or
* $6,691.13
If Francois made a one-time investment of before-tax dollars of $2,000 for 20 years at an average rate of return of 10%/year and his marginal tax bracket is 36%, what would his accumulation be after taxes?
* $13,455.63
* $13,454.99
* $6,691.13
* $8,611.20
$8,611.20
* Francois’ after tax accumulation would be
* =2,000(1.10)^20(1-.36) or
* $8,611.20.
Which of the following Models does not use after-tax dollars as the investment?
* Current Model
* Deferred Model
* Pension Model
* Tax Exempt Model
Pension Model
* The Pension Model gives the future value of an investment in a qualified retirement plan when before-tax dollars are invested.
* The three other models, Current Model, Deferred Model and Tax Exempt Model, give the future value of an investment when after tax-dollars are invested.
A Deferred Model investment will always outperform a Current Model investment when which of the following is/are true? (Select all that apply)
* The before-tax rate of returns (BTROR) is constant over time
* The BTRORs are equal across models
* Tax rates must be equal and constant over time
* The after-tax dollars are invested
The before-tax rate of returns (BTROR) is constant over time
The BTRORs are equal across models
Tax rates must be equal and constant over time
* After-tax dollars are invested in both the models.
* However, the Deferred Model always outperforms the Current Model when the BTRORs and tax rates are constant over time and equal across both models.
* This is because the earnings on the investment grow at BTROR and the investors are taxed at the end of the investment horizon.
Which of the following are examples of the Exempt Model. (Select all that apply)
* State and local government obligations
* Roth IRAs
* Deferred compensation
* Traditional non-deductible IRA
State and local government obligations
Roth IRAs
* State and local government obligations such as municipal bonds, as well as Roth IRAs, are classic examples of the Exempt Model.
Section 2 – Tax Investment Strategies
Neither taxation nor inflation should be regarded as an unmitigated evil. When incomes reach a certain level, tax-sensitive investment strategies become an integral component in making the most of the income. Federal and state tax laws play a major role in the way securities are priced in the marketplace because investors are understandably concerned with after-tax returns, not before-tax returns. Accordingly, the investor should determine the applicable tax rate before making any investment decision. Investors should also look forward to applying tax-efficient strategies, such as no-load mutual funds, bonds, and stocks.
To ensure that you have an understanding of the tax investment strategies, the following topics will be covered in this lesson:
* Mutual Funds
* Bonds
* Stocks
Upon completion of this lesson, you should be able to:
* Discuss the benefits of investing in mutual funds,
* Differentiate between individual bonds and bond funds,
* Calculate taxable bond yields and tax-exempt bond yields, and
* Discuss the benefits of purchasing stocks.
Identify the transaction that would NOT trigger a disallowed loss per the wash sale rules:
* Purchase of a call option that can be exercised into the same stock that was sold for a loss.
* An investor sells a bond at a loss, then purchases back the same exact bond.
* The purchase of a bond that is convertible to a stock that was sold for a loss.
* AAA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
AAA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
* A AA-rated bond issue from a blue-chip company is sold at a loss and the investor purchases another AA-rated bond from a different blue-chip company.
* Unless the investor purchases back the same exact bond or bond fund, it is difficult to violate the wash sale rule with fixed income.
* Since the bond is issued from different companies, loss associated with the blue-chip to blue-chip transaction would not be subject to the wash sale rules.
Section 2 – Tax Investment Strategies Summary
Federal and State tax laws play a major role in the way securities are priced in the marketplace. Based on the prices and market trends, investors need to plan and invest their money into tax-sensitive investment strategies, such as mutual funds, bonds, and common stocks.
In this lesson, we have covered the following:
* Mutual funds: High turnover rates within mutual funds could lead to taxable distributed capital gains for shareholders. Index funds have low turnover rates. There are mutual funds that are managed specifically for after-tax returns.
- Bonds: Municipal bonds offer tax-free current income but at a lower nominal yield. Therefore, these securities are only suitable for investors in higher tax brackets. Premium bond holders may amortize their loss to offset the coupons over the life of the bond. Discount bondholders can pay off their capital gain annually through accretion.
- Stocks: Tax management strategies regarding stocks revolve around capital gains. One strategy is to buy and hold stocks to make sure the capital gains are at least taxed on a long-term basis. Another strategy is to make sure that there are realized capital losses to offset realized capital gains. However, the wash sale rule will disallow certain realized capital losses to be deducted.
Which of the following type of mutual funds has the lowest turnover ratio?
* Tax-efficient Funds
* Growth and Income Funds
* Tax-managed Funds
* Index Funds
Index Funds
* Index funds have the lowest turnover ratio because the manager would not sell any of the stocks in the portfolio except when the benchmark index changes its composition.
* Tax-efficient or tax-managed funds try not to have too many short-term trades, but they will harvest losses in a down market to use later to offset capital gains.
Stella owns assets worth $1,500. In the course of a year the market value of her assets has increased to $1,800. This capital gain is not relevant for tax purposes, as she has still not exchanged her assets to buy or sell any other asset. Is this gain realized capital gain or unrealized capital gain?
* Realized
* Unrealized
Unrealized
* The capital gain that Stella makes on her asset is unrealized because she has not exchanged her assets and no tax is due on the unrealized capital gain. Also a change in the market value of a capital asset is not relevant for tax purposes until it is realized as a capital gain (or loss) by sale or exchange.
