Taxes and Private Wealth Management in a Global Context Test ID: 7426238 Question #1 of 37 Question ID: 465053 On a graph where the risk is on the horizontal axis and the returns are on the vertical axis, the existence of taxes on investment returns would probably shift the mean-variance optimization portfolio: ᅚ A) down and to the left ᅞ B) down only, and there would not be a shift left or right ᅞ C) down and to the right Explanation Taxes lower returns, but they also shift some of the investment risk to the government Question #2 of 37 Question ID: 465029 An investor deposited $33,000 in a zero coupon bond position 20 years ago It consisted of 100 zero coupon bonds each with a face value of $1,000 and 20 years to maturity The investor's current marginal tax rate is 30% At maturity, and after all taxes have been paid, the value of the position is $84,500 Compute the accrual equivalent after-tax return ᅚ A) 4.81% ᅞ B) 3.99% ᅞ C) 4.33% Explanation The accrual equivalent after-tax return = 4.81% = ($84,500 / $33,000)(1/20) − The current marginal tax rate is not relevant to solving the problem Question #3 of 37 Question ID: 465017 Among global tax regimes, the common progressive tax regime has a favorable tax treatment for: ᅞ A) interest income and dividend income but not capital gain income ᅞ B) dividend income and capital gain income but not interest income ᅚ C) interest income, dividend income, and capital gain income Explanation The common progressive tax regime tends to have a favorable tax treatment for all three Question #4 of 37 Question ID: 465019 Which of the following has favorable tax treatment under a "flat and heavy" tax regime? ᅚ A) Interest income ᅞ B) Capital gains ᅞ C) Dividend income Explanation The tax on ordinary income is flat and there is not a favorable tax treatment for dividend income and capital gain income Interest income has a favorable treatment Question #5 of 37 Question ID: 465025 The nation of Pensacola is best described as having a flat and heavy tax regime Which of the following assets would be most appropriate for Pensacola investors using a TDA? ᅞ A) Interest bearing, taxable bonds ᅚ B) High dividend yielding stocks ᅞ C) Tax-exempt bonds Explanation In a Flat and Heavy Tax Regime, interest income receives favorable tax treatment but dividends not The high dividend yielding stocks are therefore most appropriate for a TDA Tax-exempt bonds don't require the tax protection provided by a TDA Question #6 of 37 Question ID: 465023 A stock is expected to increase in value from $500 to $1,000 over a five-year period The applicable capital gains tax rate is 28% What is the expected after-tax value in five years? ᅞ A) $781 ᅚ B) $860 ᅞ C) $552 Explanation The pre-tax investment return is 14.87% =($1,000/$500)(1/5) - The formula for the future-value interest rate factor is FVIF CGT = [(1 + R)N(1 - T CG) + T CG] 1.72 = [(1.1487)5 (1 - 0.28) + 0.28] Thus, the after-tax value in five years is expected to be $860 = $500 × 1.72 Question #7 of 37 Question ID: 465020 Assume that €125,000 is invested in a tax-exempt account What is the after-tax balance in the account after 15 years if the tax rate is 28% and the pre-tax return is 11%? ᅚ A) €598,074 ᅞ B) ​465,613 ᅞ C) ​392,138 Explanation The balance in the account in 15 years uses the future value interest factor for a tax-exempt account (FVIF TEA) No taxes are due on the future accumulation FVIF TEA = (1 + R)N FV = 125,000[FVIF TEA] FV = 125,000[(1.11)15] FV = 598,074 The response of €392,138 is the future accumulation for an account taxed annually The response of €465,613 is the future accumulation for an account with tax deferred capital gains and a basis of €125,000 Question #8 of 37 Question ID: 465026 The tax rate is 34% An investment of $5,000 earns a pre-tax return equal to 8%, which is taxable each year What will the investment be worth in ten years after taxes? ᅚ A) $8,364 ᅞ B) $7,124 ᅞ C) $8,056 Explanation After-tax value = $5,000 × [1 + 0.08 × (1 − 0.34)](10) = $8,364.28 Question #9 of 37 Question ID: 465037 In a tax-exempt account, contributions to the account are made with: ᅞ A) after-tax funds and reduce the investor's current tax bill ᅚ B) after-tax funds and not reduce the investor's current tax bill ᅞ C) pre-tax funds and reduce the investor's current tax bill Explanation The tax benefit for a tax-exempt account occurs when the funds are withdrawn Question #10 of 37 Question ID: 465028 An investor deposited $54,000 in a zero coupon bond position 10 years ago It consisted of 100 zero coupon bonds each with a face value of $1,000 and 10 years to maturity The investor's average marginal tax rate is currently 20% At maturity after all taxes have been paid, the value of the position is $92,000 Compute the accrual equivalent tax rate ᅞ A) 16.27% ᅞ B) 12.18% ᅚ C) 14.00% Explanation The accrual equivalent after-tax return = 5.47% = ($92,000 / $54,000)(1/10) − The pre-tax return would have been 6.36% = ($100,000 / $54,000)(1/10) − The accrual equivalent tax rate is then 14% = − (5.47% / 6.36%) Question #11 of 37 Question ID: 465045 With respect to active investors and the tax structure in many countries, which of the following is the most accurate? ᅞ A) To offset their higher taxation, active investment managers must use taxexempt accounts ᅞ B) As a result of their lower taxation, active investment managers can remain in business even when they generate lower pre-tax returns ᅚ C) To offset their higher taxation, active investment managers must generate higher pretax returns Explanation To offset their higher taxation, active investment managers must generate higher pre-tax returns This is also true for mutual funds, especially those with high turnover, because in many countries, long-term capital gains are taxed at a lower rate and accumulate tax-free until the gains are realized Question #12 of 37 Question ID: 465047 When highest-in-first-out (HIFO) accounting is allowed, it is advisable for: ᅞ A) an investor to liquidate the portion of a position with the lowest cost basis first, thereby minimizing current taxes ᅞ B) an investor to liquidate the portion of a position with the highest cost basis first, thereby minimizing future taxes ᅚ C) an investor to liquidate the portion of a position with the highest cost basis first, thereby minimizing current taxes Explanation If an investor has accumulated a security position through a series of trades each occurring at different points in time and at different prices and if HIFO accounting is allowed by the government, the investor can liquidate the portion of a position with the highest cost basis first This minimizes current taxes As with tax loss harvesting, the total taxes over time are unchanged with HIFO accounting Question #13 of 37 Question ID: 465043 Of traders, active investors, and passive investors, which probably forgo the most tax advantages of equity? ᅚ A) Traders ᅞ B) Passive investors ᅞ C) Active investors Explanation Traders trade the most frequently, and would forgo the tax-deferred properties of equity that is allowed to grow in value over a long period Active investors trade less frequently than traders Question #14 of 37 Question ID: 465046 Which type of equity investor recognizes all gains in the short term? ᅞ A) Exempt investors ᅞ B) Active investors ᅚ C) Traders Explanation Traders forgo the tax advantages associated with equity, and therefore all gains are recognized in the short and term and taxed on an annual basis Active investors trade less frequently than traders, so they recognize gains in the long term and are taxed at lower rates Exempt investors avoid taxation altogether and hold all of their stock so no gains are recognized Question #15 of 37 Question ID: 465040 If an investment is held in an account that is taxed annually, the government bears: ᅚ A) some of the investment risk ᅞ B) all of the investment risk ᅞ C) none of the investment risk Explanation If the investment returns are taxed solely as income at the tax rate t and the pre-tax standard deviation of returns is S, then the investor's after-tax risk is S × (1 − t), and the government bears a portion of the risk Question #16 of 37 Question ID: 465033 An investor faces the periodic payment of investment income taxes With respect to the relationship between investment horizon and investment return, the tax drag is: ᅞ A) positively related to the horizon and negatively related to the investment return ᅚ B) positively related to both the horizon and investment return ᅞ C) negatively related to both the horizon and investment return Explanation Both a longer horizon and a higher return will increase the tax drag Question #17 of 37 Question ID: 465049 Chris Manning, CFA is advising a client concerning harvesting tax losses The client expects that her tax situation will not change over the next few years She asks about incurring a given loss in the current year or waiting a few years to incur the loss She asks how the decision will affect the total taxes she pays over her life Manning should advise her that: ᅞ A) she should not incur the loss this year because the HIFO principle means her total taxes will be higher if she incurs the loss this year ᅞ B) she should incur the loss this year because the HIFO principle means her total taxes will be lower if she does ᅚ C) the total tax bill over her life will not change if her tax status does not change Explanation Under the indicated conditions, i.e., the tax rate not changing in the foreseeable future, the total tax burden will be the same It is better to take losses early only to reap the gains earlier and be able to invest the gains earlier Question #18 of 37 Question ID: 465050 In applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts, the mean-variance optimization: ᅞ A) cannot simultaneously determine both the weights in the available assets and their location in the various accounts, but it can be done in a step-wise fashion Usually the weights are determined first and then the locations ᅞ B) cannot simultaneously determine both the weights in the available assets and their location in the various accounts, but it can be done in a step-wise fashion Usually the locations are determined first and then the weights ᅚ C) would simultaneously determine both the weights in the available assets and their location in the various accounts Explanation The mean-variance optimization should optimally allocate assets and determine the optimal asset location for each asset Substitution of adjusted returns would allow the process to be done in one step Question #19 of 37 Question ID: 465036 An individual, aged 40, is currently in the 25% marginal tax bracket, and expects to be in the 15% bracket when he retires Making contributions today to a tax-deductible individual retirement account is an example of: ᅞ A) deferring the timing of the tax payment ᅚ B) both minimizing the amount and deferring the timing of the tax payment ᅞ C) minimizing the amount of the tax payment Explanation The investor's action is an example of both minimizing and deferring He will minimize taxes by converting income that would have been taxed at a 25% rate today to a lower 15% rate in the future He will defer taxes payable until the funds are withdrawn from the account in the future Question #20 of 37 Question ID: 465041 Gil Tabor, CFA, and Jan Sills, CFA, are discussing how the choice of account type affects investment risk and the amount of that risk borne by the government via taxes Tabor says that the government bears some of the tax risk in a tax-exempt account Sills says the government bears some of the risk in a tax-deferred account before withdrawals occur With respect to these assertions: ᅞ A) both Tabor and Sills are correct ᅚ B) both Tabor and Sills are incorrect ᅞ C) Tabor is correct and Sills is incorrect Explanation If the investment is held in a tax-exempt account, then the investor bears all the investment risk This is also true for taxdeferred accounts before withdrawals occur because even though the government taxes the future accumulation, the variability of returns during the deferral period is not reduced by taxes levied at the time of withdrawal Question #21 of 37 Question ID: 465042 Which of the following moves by a government would most likely lead to the government taking on more investment risk? ᅚ A) Moving from a common progressive tax regime to a heavy dividend tax regime ᅞ B) Moving from a heavy dividend tax regime to a common progressive tax regime ᅞ C) Tax regimes cannot shift investment risk Explanation Moving from a common progressive tax regime to a heavy dividend tax regime would increase the tax on dividends, which are taxed annually, and this would shift some of the investment risk to the government Question #22 of 37 Question ID: 465018 With respect to the "heavy dividend" tax regime and the "heavy interest" tax regime, which if either usually has a progressive ordinary income tax structure? ᅞ A) The heavy dividend tax regime only ᅚ B) Both ᅞ C) The heavy interest tax regime only Explanation Both have progressive tax structures for ordinary income They differ on having a less favorable tax structure for the indicated source of income Question #23 of 37 Question ID: 465044 With respect to traders and active investors, which of the following statements is the most accurate? ᅞ A) Active investors trade as frequently as traders but they use strategies that lead to their gains being taxed at higher rates ᅚ B) Active investors trade less frequently than traders so that many of their gains are taxed at lower rates ᅞ C) Active investors trade more frequently than traders so that many of their gains are taxed at lower rates Explanation Traders trade more frequently Therefore, traders generally pay higher tax rates Question #24 of 37 Question ID: 465048 The main benefit of tax-loss harvesting is: ᅚ A) saving on current taxes ᅞ B) saving on future taxes ᅞ C) reducing both current and future taxes Explanation Although tax loss harvesting saves on current taxes, the apparent tax savings in a given year are misleading This is because when the security is sold and the proceeds are reinvested, the cost basis of the new, replacement security is the low sales price of the old security In other words, when the old security is sold, the cost basis for future taxes is reduced, thereby resulting in higher taxes in the future Question #25 of 37 If an investment is held in a tax-exempt account, then the investor bears: ᅚ A) all of the investment risk ᅞ B) some of the investment risk Question ID: 465039 ᅞ C) none of the investment risk Explanation In a taxable account, losses realized result in a reduction in taxes that serve to offset the magnitude of the loss Thus, some of the downside risk is transferred to the government In a tax-exempt account, the variability of returns is not affected by the taxes Question #26 of 37 Question ID: 465027 Given an accrual equivalent after-tax return equal 6% and a pre-tax return equal to 7.2%, what is the accrual equivalent tax rate? ᅞ A) 20.00% ᅞ B) 12.93% ᅚ C) 16.67% Explanation The accrual equivalent after-tax rate is: 0.1667 = 16.67% = − (6% / 7.2%) Question #27 of 37 Question ID: 465021 Assume that €125,000 is invested in a TDA What is the after-tax balance in the account after 15 years if the tax rate is 28% and the pre-tax return is 11%? ᅚ A) €430,613 ᅞ B) ​598,074 ᅞ C) ​392,138 Explanation The balance in the account after payment of taxes in 15 years uses the future value interest factor for a TDA (FVIF TDA): FVIF TDA = (1 + R)N (1 − T N) FV = 125,000[FVIF TDA] FV = 125,000[(1.11)15(1 − 0.28) FV = 430,613 Question #28 of 37 Question ID: 465035 Sam Conner and Bill Pope live in different countries In Conner's country, there is a light capital gain tax regime In Pope's country there is a heavy capital gain tax regime They both are building diversified portfolios that hold non-dividend-paying growth stocks, dividend-paying stocks, and coupon-paying bonds They both have a buy-and-hold strategy Which, if either, would probably benefit the most from a tax-deferred account (TDA)? ᅞ A) Pope would benefit more than Conner ᅚ B) Conner would benefit more than Pope ᅞ C) Neither would benefit because tax-deferred accounts little to enhance the returns of diversified portfolios Explanation Conner would benefit more In a light capital gain tax regime, dividends and interest not receive favorable tax-treatment There would be an advantage to having them in the TDA In the heavy capital gain tax regime, interest and dividends receive tax advantages Question #29 of 37 Question ID: 465030 You compute that an investment with a current value and basis equal to $20,000 will have an annual pre-tax return equal to 10% for the next 12 years until it is sold The effective capital gains rate will be 15% What will be the accrual equivalent aftertax return? ᅚ A) 9.02% ᅞ B) 12.50% ᅞ C) 8.50% Explanation The balance in the account after payment of all taxes in 12 years uses the future value interest factor after all taxes: Future value = $20,000 × [((1.1)12) × (1 − 0.15) + 0.15] = $56,353 The accrual equivalent after-tax return is then ($56,353 / $20,000)1/12 − = 9.02% Question #30 of 37 Question ID: 465038 An investor holds the same investment in three different accounts Which of the following accounts will have the lowest risk? ᅞ A) A tax-exempt account ᅚ B) A taxable account ᅞ C) A TDA Explanation The taxable account will have the lowest risk because the government essentially shares the risk of the investment with the investor when it is taxed annually When taxed annually, the standard deviation of the investment returns is reduced by (1- T I) Question #31 of 37 In applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts, Question ID: 465051 ᅚ A) constraints should be imposed to account for the limits that can be put in taxexempt accounts ᅞ B) no considerations need to be made because total taxes will be the same in the long run ᅞ C) the investor should set up two separate frontiers and optimize each in accordance with the separation theorem Explanation A single frontier can be formed, and the optimization process would have to be constrained to account for limits on the amount of funds that can be placed in tax advantaged accounts and the type of assets that can be allocated to them Question #32 of 37 Question ID: 465022 An investor has €600,000 invested in equity in a TDA and €400,000 invested in bonds in a tax-exempt account The relevant tax rate is 35% What is the investor's asset allocation on an after-tax basis? ᅞ A) 44.9% in stocks and 55.1% in bonds ᅞ B) 69.8% in stocks and 30.2% in bonds ᅚ C) 49.4% in stocks and 50.6% in bonds Explanation The investor has €390,000 [(€600,000 × (1 - 0.35)] invested in equity on an after-tax basis The bonds in the tax-exempt account are not subject to taxation On an after-tax basis, the investor has 49.4% in equity [390,000 / (390,000 + 400,000)] and the other 50.6% in bonds [400,000 / (390,000 + 400,000)] Question #33 of 37 Question ID: 465034 An investor who lives in a country with a flat tax regime is trying to decide whether to open a tax-deferred account or a taxexempt account for retirement savings The investor would: ᅞ A) choose a tax exempt account over a tax-deferred account if the investor thought her income would be lower after retirement ᅚ B) be indifferent between the two accounts as long as the flat tax rate does not change ᅞ C) choose a tax exempt account over a tax-deferred account if the investor thought her income would be higher after retirement Explanation If the tax rate does not change either from a change in the investor's income or a change in the tax law, the future value will be the same Question #34 of 37 Question ID: 465052 Which of the following most accurately describes the process for adjusting the returns when applying efficient frontier analysis for an investor who uses both taxable and tax-advantaged accounts? ᅞ A) Accrual equivalent before-tax returns would be substituted for after-tax returns and after-tax risk would be substituted for before-tax risk ᅞ B) Accrual equivalent before-tax returns would be substituted for after-tax returns and before-tax risk would be substituted for after-tax risk ᅚ C) Accrual equivalent after-tax returns would be substituted for before-tax returns and after-tax risk would be substituted for before-tax risk Explanation The mean-variance optimization should optimally allocate assets and determine the optimal asset location for each asset Accrual equivalent after-tax returns would be substituted for before-tax returns and after-tax risk would be substituted for before-tax risk Question #35 of 37 Question ID: 465024 All else being equal, which of the following investors will have the highest future accumulations? ᅞ A) An active investor ᅚ B) A passive investor ᅞ C) A trader Explanation The passive investor will pay a low tax rate on a deferred basis and have the highest accumulation of the three investors The active investor will have the next lowest future accumulation because although gains are taxed at a lower rate, the gains are taxed every year The trader will have the lowest future accumulation because her capital gains will be short-term and taxed at a high rate The gains will also be taxed every year Question #36 of 37 Question ID: 465032 If the tax rate is positive and there is periodic payment of investment income taxes, then which of the following relationships is most accurate? ᅞ A) Tax drag < tax rate ᅚ B) Tax drag > tax rate ᅞ C) Tax drag = tax rate Explanation Under the given conditions: tax drag > tax rate This is because the tax rate is being applied periodically to a value (the taxable gain or investment income) that is increasing at a compound rate Question #37 of 37 Question ID: 465031 The tax drag from both longer investment horizons and higher investment returns: ᅚ A) have a multiplicative effect, so that the tax drag increases rapidly as the investment horizon and the returns increase ᅞ B) are unrelated, and each has a linear relationship with cash drag that is independent of the other ᅞ C) have an offsetting effect, so the tax drag can be zero in some cases where the investment horizon and returns are greater than zero Explanation They are multiplicative in the formula Thus, when both are increased, the tax drag rapidly increases  ... the following has favorable tax treatment under a "flat and heavy" tax regime? ᅚ A) Interest income ᅞ B) Capital gains ᅞ C) Dividend income Explanation The tax on ordinary income is flat and there... for an investor who uses both taxable and tax-advantaged accounts, the mean-variance optimization: ᅞ A) cannot simultaneously determine both the weights in the available assets and their location... determine both the weights in the available assets and their location in the various accounts Explanation The mean-variance optimization should optimally allocate assets and determine the optimal asset