# 11

## 17 terms · Taxes and Private Wealth Management in a Global Context

### Types of taxes

Ordinary income taxes:
- flat or progressive
Investment income tax: may be favorable
- interest income
- Dividends
- Capital gains

### Calculating Taxes Due

Progressive income tax system
Plus = addition of al previous taxes

...

### Accrual taxation

paid periodically (annually)
tax drag
structure PF to avoid accrual taxation

### Tax drag

is the reduction in return caused by the payment of any type of taxes
- tax drag dollar = amount of total gain lost to taxes
- tax drag % = % of total gain lost to taxes
- tax drag % > tax rate
- both increase with loner holding periods and return rate

### Capital gains taxes

- CAN BE AVOIDED
- taxes paid on the gain (long or short pos) when an asset is sold or purchased
- CG = difference purchase and selling price = tax basis
- LT CGs are often taxed at a reduced rate
- CGs can be timed to delay payment of taxes
- "HArvest" capital losses to offset capital gains and reduce taxes
COST BASIS???
as basis falls, tax drag increases

### Wealth Taxes

tax on the entire value of assets held
- principal + earnings
- assumes beg 1000 balance has already been taxed
- same effect as accrual tax (?)
- but lower return increases diminishment (?)

### Accrual Equivalent Returns

RAE
- Effective (after-tax) geometric return
- after less than the annual taxble (berfore-tax) return
- difference between the two is determined by the investment horizon and the proportion of the total gain that is deferred
- The greater the proportion of return that is deferred, the greater the value of the tax deferral
- time horizon up, value up.
- accrual equivalent tax rate TAE
-- tax rate that makes pre-tax return equal to RAE

### Summary of relationships

- accrual taxes (> 1 year) : tax drag % > tax rate
-- inv horizon rises, tax drag % and \$ rises
-- inv return rises, tax drag % and \$ rises
- Deferred CG taxes, B=1, Tax Drag % = tax rate
- Deferred CG taxes, B<1, Tax Drag % > tax rate
-- as B% falls -> tax drag % and tax drag \$ rise
--- inv horizon rises -> tax drag unchanged, value of tax deferral increases
--- inv return rises -> tax drag unchanged, value of tax deferral increases
-- B% falls -> RAE falls
-- B% falls -> TAE rises

### Account Tax Profiles

Taxable
- taxes paid annually

Tax-deferred
-front-end benefits, PV is before-tax

Tax-exempt
- back-end benefits, PV is after-tax

### Tax-exempt or tax-deferred?

tax exempt: taxes are paid at t=0
tax-deferred, taxes are paid at t=N
- Ceteris paribus, difference in final "spendable cash" is due to differences in the current tax rate and expected future tax rate

taxable income/Tax rate lower today -> use tax-exempt
taxable income/tax rate in the future -> use tax-deferred

### Taxes and investment risk

in a taxble accont, governemnt shares both gains and losses
- taxes actually reduce the range of returns from the investor's perspective
- reduced standard deviation!!

### Trading behavior, taxes and returns

Tax alpha
- extra inv value created by effective tax management
- any amount of taxes not paid remains in the account to earn future (compounded) returns
- Low current income (e.g. equities) -> hold in taxable accounts
- High current income (e.g. bonds) -> hold in tax protected accounts

Four types of investors
- all gains ST, few tax benefits
2. Active investor
- less churn, some gains taxed at reduced rates
3. Passive investor
- Buy and hold, most gains are deferred
4. Exempt investor
- no investment taxes

### Tax Loss Harvesting

Use losses to offset gains
Reinvestment caveat
- if security is harvested, the selling price of the old security becomes the tax basis for the new security -> tax only deferred!
-- only time value benefit!!

### Highest-in, First-out accounting

HiFo
-> maximizes the loss for harvesting
or
-> minimize the taxable gain

### Lowest-in, First-out accounting

If tax rates are expected to rise, the investor could choose LIFO
- allows to slect the lot with lowest cost absis
- maximize realized gains before effective tax rate increases

### Asset Location and Optimization

When possible:
- HOld high return (high income) assets in tax-exempt accounts, e.g. 401K
- Hold low return (low income) assets in taxable accounts -> taxable portfolio