Tax considerations and private client investments

Common Tax Categories

• Taxes on income: These include taxes on salaries, interest, dividends, capital gains, and rental income.
• Wealth-based taxes: These include taxes on the holding of certain types of property and taxes on the transfer of wealth.
• Taxes on consumption/spending: Sales taxes, and value-added taxes.

Basic Tax Strategies

Taxes are normally reflected in a private client’s financial plan and asset allocation decisions. While an in-depth discussion of tax strategies is beyond the scope of this reading, the following considerations are common to many clients:

• Tax avoidance: Tax avoidance is a common goal of individuals. Tax avoidance differs from illegal tax evasion. Depending on the country, investors may be allowed to contribute a restricted amount to certain accounts that are tax-free and can be withdrawn tax-free. Another example of tax avoidance involves various wealth transfer techniques, like annual gift allowances.
• Tax reduction: Private wealth managers typically try to reduce the tax burden on their clients. For example, a wealth manager may recommend tax-exempt bonds that can produce a higher after-tax return than taxable bonds. Or a wealth manager may recommend limiting investment in asset classes with less favorable tax characteristics while increasing exposure to more tax-efficient asset classes.
• Tax deferral: When certain taxes are deferred and recognized at a later date, clients can reap the benefits of compounding portfolio returns that aren’t diminished by periodic tax payments. Some investors in a progressive tax system may also seek to defer taxes because they believe future tax rates may be lower. This could include delaying the sale of positions with capital gains, yet to be realized.

Question

Gifting funds to a minor is best described as an example of tax:

1. Deferral.
2. Reduction.
3. Avoidance.

Solution

The correct answer is C.

Many countries permit annual allowances of gifts to be made, tax-free. In the US, this has recently been up to $15,000 annually. In making the gift, the taxable estate of the gift giver is reduced, thereby avoiding future wealth transfer taxes (provided the lifetime exclusion is not met).

A is incorrect. Answer choice A is not strong enough, as it means only delaying a tax, but still paying it in the future.

B is incorrect. Answer choice B is also not strong enough, in the sense that taxes are not being reduced here but avoided altogether.

Reading 7: Overview of Private Wealth Management

Los 7 (c) Identify tax considerations affecting a private client’s investments