Reading 10 Taxes and Private Wealth Management in a Global Context www.irfanullah.co Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Introduction Overview of Global Income Tax Structures After-Tax Accumulations and Returns For Taxable Accounts Types of Investment Accounts Taxes and Investment Risk Implications for Wealth Management www.irfanullah.co 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 www.irfanullah.co 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 www.irfanullah.co Example Progressive Tax Rate Structure Ordinary income Investment income often taxed differently based on the nature of the income: Interest, dividends, capital gains Common Progressive Regime Heavy Dividend Tax Regime Heavy Capital Gain Tax Regime Heavy Interest Tax Regime Light Capital Gain Tax Regime Flat and Light Regime Flat and Heavy Regime www.irfanullah.co After-Tax Accumulations and Returns for Taxable Accounts Returns-Based Taxes: Accrual Taxes on Interest and Dividends www.irfanullah.co Example Flat Tax Rate = 20% 7% return over 20 years Initial portfolio 100,000 Expected wealth after 20 years? What portion of investment gains consumed by taxes? www.irfanullah.co Returns-Based Taxes: Deferred Capital Gains www.irfanullah.co Example Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years What is the expected wealth at the end of 20 years? What portion of investment gain consumed by taxes? www.irfanullah.co Cost Basis www.irfanullah.co 10 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: www.irfanullah.co 15 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 www.irfanullah.co 16 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 years after taxes Accrual equivalent return is 10% Embedded example: 100  138.66 in years after taxes What is accrual equivalent return? Accrual Equivalent Tax Rates www.irfanullah.co 17 Example Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years What is the accrual equivalent return? What is the accrual equivalent tax rate? www.irfanullah.co 18 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 www.irfanullah.co 19 Example 10 100,000 for 20 years 7% return Tax = 20% Compute after-tax wealth after 20 years: Taxable account, taxed annually Taxable account Deferred capital gains tax Tax deferred account Tax exempt account www.irfanullah.co 20 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 www.irfanullah.co 21 4.4 Choosing Among Account Types TDE seems better than TDA but… Contributions to TDA are tax deductible Investors tax rate might be lower upon withdrawal Example 11 www.irfanullah.co 22 Taxes and Investment Risk For assets in taxable accounts: Taxing authority shares investment risk with investor Hence, taxes can reduce investment risk See Exhibit if you want to be super diligent For assets in TDAs and TEAs: Investor bears all risk associated with returns www.irfanullah.co 23 Implications for Wealth Management Techniques for effectively managing tax liabilities  Tax Alpha 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 www.irfanullah.co 24 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 Accounts Taxable Accounts Securities which would otherwise be heavily taxed Lightly taxed securities www.irfanullah.co 25 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 www.irfanullah.co 26 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 Example 13 Recognizing already incurred loss for tax purposes increases after-tax money available for investments Example 14 Highest In First Out (HIFO) www.irfanullah.co 27 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 www.irfanullah.co 28 Review learning objectives Examples Practice Problems www.irfanullah.co 29 ... Flat and Heavy Regime www.irfanullah.co After-Tax Accumulations and Returns for Taxable Accounts Returns-Based Taxes: Accrual Taxes on Interest and Dividends www.irfanullah.co Example Flat Tax... Dividend and realized capital gains taxed at 15% Interest taxed at 35% Look at Exhibit www.irfanullah.co 16 3.3 Accrual Equivalent Returns and Tax Rates Accrual equivalent after-tax return is the tax-free... years after taxes What is accrual equivalent return? Accrual Equivalent Tax Rates www.irfanullah.co 17 Example Invest 100,000 at 7% for 20 years Pay tax on capital gain at end of 20 years What