Level III

Taxes and Private Wealth Management in a Global Context

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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
 Contents
1. Introduction
2. Overview of Global Income Tax Structures
3. After-Tax Accumulations and Returns For Taxable Accounts
4. Types of Investment Accounts
5. Taxes and Investment Risk
6. Implications for Wealth Management

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 1. 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

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2. 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

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Example 1. Progressive Tax Rate Structure

Ordinary income
Investment income often taxed differently based on the nature of the income:
Interest, dividends, capital gains

1. Common Progressive Regime

2. Heavy Dividend Tax Regime

3. Heavy Capital Gain Tax Regime

4. Heavy Interest Tax Regime

5. Light Capital Gain Tax Regime

6. Flat and Light Regime

7. Flat and Heavy Regime

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3. After-Tax Accumulations and Returns for Taxable Accounts

Returns-Based Taxes: Accrual Taxes on Interest and Dividends

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Example 2. Flat Tax Rate = 20% 7% return over 20 years Initial portfolio 100,000
1. Expected wealth after 20 years?
2. What portion of investment gains consumed by taxes?

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Returns-Based Taxes: Deferred Capital Gains

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Example 3. Invest 100,000 at 7% for 20 years. Pay tax on capital gain at end of 20 years.
1. What is the expected wealth at the end of 20 years?
2. What portion of investment gain consumed by taxes?

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Cost Basis

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Example 4. Current market value = 100,000. Cost basis = 80,000. 7% and 20 years.

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Wealth-Based Taxes

Example 5. Wealth tax of 1.0% on final assets each year. Portfolio of 400,000 is expected to return 6%
for the next 10 years.
1. Expected wealth at end of 10 years?
2. Proportion of investment gains consumed by taxes?

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 3.2 Blended Taxing Environments
Different taxing schemes can be integrated into a single framework

Consider portion of investment return from interest, dividend and capital gain

Example 6. Portfolio = 100,000. Grows to 108,000 by year end. Interest = 400, Dividend = 2,000 CG = 3,600

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 Annual return after realized taxes

Example 7. Portfolio = 100,000. Grows to 108,000 by year end. Interest = 400, Dividend = 2,000 CG = 3,600
Dividend and realized capital gains taxed at 15%. Interest taxed at 35%.
1. What is the annual return after realized taxes?
2. What is the balance at the end of the year after taxes are paid?

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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:

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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 5.

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 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 2 years after taxes

Accrual equivalent return is 10%

Embedded example: 100  138.66 in 5 years after taxes. What is accrual equivalent return?

Accrual Equivalent Tax Rates

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Example 9. Invest 100,000 at 7% for 20 years. Pay tax on capital gain at end of 20 years.
1. What is the accrual equivalent return?
2. What is the accrual equivalent tax rate?

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 4. 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

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Example 10. 100,000 for 20 years. 7% return. Tax = 20%. Compute after-tax wealth after 20 years:
1. Taxable account, taxed annually.

2. Taxable account. Deferred capital gains tax.

3. Tax deferred account

4. Tax exempt account

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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.

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4.4 Choosing Among Account Types

TDE seems better than TDA but…

1. Contributions to TDA are tax deductible

2. Investors tax rate might be lower upon withdrawal

Example 11

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 5. Taxes and Investment Risk

For assets in taxable accounts:

Taxing authority shares investment risk with investor

Hence, taxes can reduce investment risk

See Exhibit 7 if you want to be
super diligent

For assets in TDAs and TEAs:

Investor bears all risk associated with returns

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 6. 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

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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 Taxable Accounts

Accounts

Securities which would Lightly taxed securities

otherwise be heavily
taxed

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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

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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)

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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

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Review learning objectives

Examples

Practice Problems

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