Elements of Return and Taxation Status for the Account

To make optimal after-tax investment decisions for clients, wealth managers focus on three crucial aspects:

1. Component Returns Taxation: This involves understanding how different investment components, like dividends, capital gains, and interest, will be taxed.
2. Account Taxable Status: Wealth managers determine whether client accounts are taxable, non-taxable, or tax-advantaged.
3. Client Jurisdiction: This considers the governmental rules governing investment accounts and any special factors, such as tax treaties, affecting investment decisions.

Component Returns Taxation

Taxes depend on where funds come from and how taxation is defined and regulated by the jurisdiction. Key components subject to taxation include:

• Income Tax: Tax on earnings.
• Gains Tax: Tax on wealth accumulation in investment accounts.
• Wealth Tax: Tax on the total accumulation of earnings and wealth, often levied annually.
• Stamp Duties: Upfront taxes related to share or real estate purchases.
• Wealth Transfer: Also known as inheritance tax.

Interest Dividends and Withholding Taxes

Double Taxation: Imposing a tax twice, often avoided by governments with tax treaties, but some investors still face it depending on their jurisdiction.

Qualified Dividends: Earnings from equity ownership with generally favorable tax treatment, often subject to specific conditions like holding the asset for a certain duration or investing in a particular type of firm.

Withholding Taxes: Taxes held back by one jurisdiction on a portion of earnings or investment income, potentially subject to further taxation by another jurisdiction.

Capital Gains Tax

Capital gains taxes apply to the increase in the value of an investment.

Cost (Tax) Basis

Cost basis is the original purchase price of an investment, used as the starting point for tax calculations. It's crucial for capital gains and sometimes applies to interest or options with reduced cost bases.

The tax basis is the cornerstone for determining a capital gain or loss, which is the selling price (after deducting commissions and other trading expenses) minus the tax basis.

Capital gains can be either realized or unrealized. A realized capital gain is the profit recorded upon the sale of an asset. An unrealized capital gain is the increase in value of an asset that is still part of the portfolio. If an asset is sold at a loss, this loss can frequently be used to counterbalance a realized capital gain.

Holding Period

Long-term investments, typically held for over a year, often receive preferential tax treatment. For instance, in the US, short-term gains (held less than a year) are taxed at regular income rates, while long-term gains have lower tax rates.

Real Estate Taxes

Real estate investments often face higher taxes than personal homes. Tax benefits may include deductions for:

• Interest income.
• Maintenance costs.
• Depreciation.

Some countries allow property exchanges to delay capital gains taxes, reducing transaction costs.
a delay in capital gains tax, thus lowering the burden of the transactions.

Account Tax Status

Investors may hold investments in a variety of account types, all of which affect the after-tax value of the investments within.

Taxable Accounts: These accounts offer no tax advantages, neither on a deferred or up-front basis.

Tax-deferred accounts (“TDA”): These accounts offer an initial tax reprieve, accumulate tax-free, and then impose taxes on the withdrawals.

The formula for future value of a TDA is as follows:

$$
FV_{TDA} = (1+ r)^n (1-T_n) $$

Where:

\(FV_{TDA}\) = Future value of the account.

\(r\) = Rate of return.

\(T\) = Tax rate.

\(n\) = Number of periods.

Tax-exempt accounts (“TEA”): These accounts are funded with post-tax dollars and then accumulate and enjoy tax-free withdrawals. The fact that the assets are post-tax, means that the funds have already been taxed, and no up-front advantage is given, as with the deferred accounts.

$$ FV_{TEA} = (1+ r)^n $$

Where:

\(FV_{TEA}\) = Future value of the account.

\(r\) = Rate of return.

\(n\) = Number of periods.

It is important to remember the potential need to account for the taxation of the dollars before they go into the account, should the question require that.

Question

$$ \begin{array}{c|c|c}
\textbf{Account Type} & \textbf{Asset Classes} & \textbf{Pre-tax Market Value} \\ \hline
\text{TDA} & \text{Stock} & \$10,000 \\ \hline
\text{TEA} & \text{Bond} & 30,000
\end{array} $$

Using the information above, and assuming a capital gains tax rate of 40%, the after-tax asset allocation of stocks in the portfolio is closest to?

1. 25.00%.
2. 16.68%.
3. 83.33%.

Solution

The correct answer is B.

$$ \begin{array}{c|c|c|c|c}
\textbf{Account} & \textbf{Asset} & \textbf{Pre-tax} & \textbf{After-tax} & \textbf{After-Tax} \\
\textbf{Type} & \textbf{Classes} & \textbf{Market Value} & \textbf{Market Value} & \textbf{Weight} \\ \hline
\textbf{TDA} & \text{Stock} & \$10,000 & 6,000 & 16.68\% \\ \hline
\textbf{TEA} & \text{Bond} & 30,000 & 30,000 & 83.33\% \\ \hline
\textbf{Total} & & \bf{\$40,000} & \bf{\$36,000} &
\end{array} $$

The key to answering this question lies in computing the after-tax market value of the TDA account, which holds the stocks. Since it is subject to a reduction of 40% upon sale, its after-tax value is $6,000. Using this, we can compute new after-tax weightings of 16.68% for the stock, and 83.33% for the bonds.

A and C are incorrect. The TDA account's after-tax market value, which is $6,000 due to a 40% reduction upon sale, allows us to calculate new after-tax proportions of 16.68% for stocks and 83.33% for bonds.

Reading 8: Topics in Private Wealth Management

Los 8 (a) Compare taxation of income, wealth, and wealth transfers

Los 8 (b) Describe global considerations of jurisdiction that are relevant to taxation