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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

Different tax regimes


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

- 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
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

- 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

- taxes paid annually

-front-end benefits, PV is before-tax

- 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
1. Traders
- 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

-> maximizes the loss for harvesting
-> 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

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