Level III

Taxes and Private Wealth Management

Summary

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 Basic Global Taxation Regimes

Regime Common Heavy Heavy Capital Gain Heavy Interest Light Capital Flat and Light Flat and Heavy
Progressive Dividend Tax Tax Tax Gain Tax

Ordinary
Tax Rate Progressive Progressive Progressive Progressive Progressive Flat Flat
Structure

Taxed Taxed Taxed

Interest Taxed favorably or Taxed at ordinary Taxed at ordinary Taxed favorably
favorably or favorably or favorably or
Income exempt rates rates or exempt
exempt exempt exempt

Taxed Taxed
Taxed at Taxed favorably or Taxed favorably Taxed at ordinary Taxed at ordinary
Dividends favorably or favorably or
ordinary rates exempt or exempt rates (flat) rates
exempt exempt

Taxed Taxed Taxed

Capital Taxed at ordinary Taxed favorably Taxed favorably Taxed at ordinary
favorably or favorably or favorably or
Gains rates or exempt or exempt (flat) rates
exempt exempt exempt

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 Impact of Taxes on Future Wealth
Future value factor Example
Returns-based taxes: FVIFi = [1 + r(1 – ti)]n Amount = 100, r = 7%, n = 20 years and t = 20%:
accrual taxes on interest FV = 100 × [1 + 0.07(1 – 0.20)]20 = 297
and dividends Without taxes, FV = 387. Difference = 90
Tax impact = 90 / 287 = 31% which is > 20%
Returns-based taxes: FVIFcgb = (1 + r)n(1 – tcg) + tcgB Scenario 1: Amount = 100, cost basis = 100,
deferred capital gains r = 7%, n = 20 years and t = 20%
FV = 100 × [(1 + 0.07)20(1 – 0.20) + 0.20] = 330 > 297

Scenario 2: Amount = 100, cost basis = 80,

r = 7%, n = 20 years and t = 20%
FV = 100 × [(1 + 0.07)20(1 – 0.20) + 0.20(0.80)] = 326
Wealth-based taxes FVIFw = [(1 + r)(1 – tw)]n Amount = 400, r = 6%, n = 10 years and t = 1%:
400*(1.06)(1 − 0.01)+10 = 648, or gain = 248
Without tax: 400 x 1.0610 = 716, gain 316
(316 – 248) / 316 = 21.5%.
A 1% wealth tax consumed 21.5% of the gain.

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 Impact of Investment Return and Time Horizon on Taxes

When investment returns are subject to accrued taxes on annual basis:

 Tax drag > nominal tax rate

 All else equal, as investment horizon increases  tax drag increases

 All else equal, as investment return increases  tax drag increases

 Given investment returns, the longer the time horizon, the greater the tax drag

 Given investment time horizon, the higher the investment returns, the greater
the tax drag

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 Blended Tax Environment
Formula / Example
Annual return after realized r* = r (1 – pi ti – pd td – pcg tcg)
taxes
r* = 8%[1 – (0.05 × 0.35) – (0.25 × 0.15) – (0.45 × 0.15)] = 7.02%

Effective capital gains tax rate T* = tcg(1 – pi – pd – pcg)/(1 – piti – pdtd – pcgtcg)
(recognizes that income and
realized capital gains have been = 0.15*(1 − 0.05 − 0.25 − 0.45)/(1 − 0.05 × 0.35 − 0.25 × 0.15 − 0.45 × 0.15)]
taxed) = 0.15(0.25/0.8775) = 4.27%

Future after-tax accumulation FVIFTaxable = (1 + r*)n(1 – T*) + T* – (1 – B)tcg  

for each unit of currency in a
taxable portfolio 100 [(1.0702)5(1 − 0.0427) + 0.0427 − (1 − 1.00)0.15+ = 139

Accrual-equivalent return If we start with 100 and end with an after-tax amount of 139 after 5
years then: 100(1 + RAE)5 = 139

Accrual-equivalent tax rate r(1 – TAE) = RAE

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 Investment Accounts – Tax Profiles
Description Future Value
Taxable Account Contributions are after-tax Discussed previously.
Returns are taxed

Tax-Deferred Contribution are pre-tax 𝐅𝐕𝐈𝐅𝐓𝐃𝐀 = 𝟏 + 𝒓 𝒏 (𝟏 − 𝑻𝒏 )

Accounts (TDAs) Returns accumulate on tax-deferred basis until
funds are withdrawn; taxed at ordinary rates
Tax-Exempt Contributions are after-tax 𝐅𝐕𝐈𝐅𝐓𝐚𝐱𝐄𝐱 = 𝟏 + 𝒓 𝒏

Accounts Returns are not taxed

• If future taxes are expected to be lower than current taxes  tax-deferred accounts are better
• If future taxes are expected to be higher than current taxes  tax-exempt accounts are better
• Tax alpha: value generated by using techniques that effectively manage tax liabilities.
• Asset location decision: choice of where to place the specific assets
 Heavily-taxed assets should be held in tax-sheltered accounts.
 Lightly-taxed asset should be held in taxable accounts.

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Taxes and Investment Risk
• For assets in taxable accounts, taxes reduce both investment Investors after-tax risk = σ (1 - T)
risk and return.
• For assets in TDA’s and tax exempt accounts, investor bear all
risk associated with returns.

After-tax Returns and Trading Behavior

• Many tax regimes encourage longer term investments
• If tax on short term gains > tax on long term gains  Reduce short-term trading
• Active managers must earn greater pre-tax returns than passive managers to offset
tax drag of active trading

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 Tax Loss Harvesting, HIFO and MVO

Tax loss harvesting: realizing capital losses to offset taxable gains in that tax This strategy postpones the
year  decrease in the current year’s tax liability payment of taxes.

Best used when tax rates are relatively high. Deferring taxes may not be a desirable
strategy if tax rates are expected to increase.

Highest-in, first-out (HIFO): highest cost basis lots are sold first to defer the tax
on the low cost basis lots, resulting in decrease in current capital gain taxes.

Reinvesting current year’s tax savings increases the after-tax principal

investment.

• Traditional mean-variance optimization should be modified to accommodate after-tax risk and return.
• Mean variance optimization algorithm should use after-tax standard deviations of returns and accrual
equivalent returns rather than pretax standard deviations and pretax returns.
• An after-tax portfolio optimization model that optimizes asset allocation also optimizes asset location.

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