Fixed-income Portfolios for Taxable and Tax-exempt Investors

Taxable and Tax-exempt Investors

Taxable and tax-exempt investors share a common goal of maximizing risk-adjusted returns. The CFA exam is designed with a global perspective and does not require candidates to possess specific country knowledge. Nevertheless, noting several similarities in the tax treatment of fixed-income investments worldwide is beneficial.

Income Vs. Capital Gains Taxation Common Issues

• Taxation on income and capital gains is subject to different rates. Zero-coupon bonds may incur imputed interest charges, payable for the period earned, even without an underlying cash flow.
• Capital gains are typically taxed only at the point of sale, and the rates are usually lower than income taxes, which are imposed when they are received.
• Capital losses may be used to offset capital gains, and in some cases, they can be carried forward to offset gains in the future.
• Tax-advantaged accounts often have restrictions on the types of fixed-income securities they can contain, favoring more tax-efficient options.

Strategies for Taxable Accounts

To optimize tax management, consider the following approaches:

• Realize capital losses strategically to offset gains and reduce overall tax liability.
• Minimize short-term gains by holding securities for extended periods to take advantage of lower long-term capital gains rates.
• Defer taxes further by extending the holding periods, which can compound tax-deferred growth.
• Before making investment decisions, carefully study the income versus capital gains tax treatment in your local jurisdiction to make tax-efficient choices. Understanding the tax implications can help you make informed investment choices that align with your tax goals and financial strategy.

Pooled Asset Taxation

When investors buy ETFs, mutual funds, or other pooled assets with fixed-income investments, it's essential to consider the local jurisdiction's policy on pass-through taxation of gains. While income tax is typically due from the investors in the fund, pass-through taxation may or may not be allowed in certain areas. Therefore, investors in regions where pass-through taxation is not permitted should consider this before making investment decisions.

Question

Which of the following taxable account strategy descriptions is the least accurate?

1. Realize capital losses to offset capital gains.
2. Avoid short-term gain rates by holding securities for more extended periods.
3. Defer taxes by shortening holding periods.

Solution

The correct answer is C.

C is the least accurate because it suggests deferring taxes by shortening holding periods, which is incorrect. In reality, taxes are deferred by extending holding periods.

A is incorrect: Capital losses can be used to offset capital gains.

B is incorrect: Holding securities for extended periods can help avoid short-term gains.

Portfolio Construction: Learning Module 2: Overview of Fixed-Income Portfolio Management; Los 2(f) Discuss differences in managing fixed-income portfolios for taxable and tax-exempt investors