tax-efficient investment strategies chapter 44 tools & techniques of investment planning...
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Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 1
Tax Exempt Equivalent (Taxable Equivalent Yield)
• Some bonds are taxable while others are not.– It is useful to convert:
• A taxable yield to an after-tax yield• A tax exempt yield to a taxable equivalent yield
– Comparisons can then be made between taxable and nontaxable yields on an equivalent basis.
• Since most bonds are subject to federal income tax, it is useful to express these yields on an after-tax basis:– After Tax Yield = Before Tax Yield X (1 – Tax Rate)
• In the case on of a nontaxable bond, the process can be reversed to determine the tax exempt equivalent of a tax exempt bond:– Tax Exempt Equivalent = Tax Exempt Yield / (1- Tax Rate)
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 2
Ordinary Income, Capital Gain, and Qualified Dividends• Favorable tax rates exist for capital gains and qualified
dividends.– Capital gains and qualified dividends are generally taxed at a
maximum rate of 15%.– Ordinary income is currently taxed at a maximum rate of 35%.– The taxation of capital appreciation of property can generally
be postponed until the property is sold.
• Future Value of an Investment– FV = PV X (1 + r)n
– Adjustment for taxes• FV = PV X (1 +( r X (1 – td))n
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 3
Ordinary Income, Capital Gain, and Qualified Dividends• The following formula can be used to calculate the
future value of an investment where part of the returns will be taxed current as ordinary income or qualified dividends and part will be taxed on distribution as capital gains:– FV = PV X [(1+ar)n-td X (g X r X ((1+ar)n-1/ar)+b)]
• If ar =/= 0
– FV = PV X (1 – td x b)
• If ar = 0
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 4
Timing of Capital Gain or Loss
• A person who owns capital property may be able to control when gain or loss is recognized for tax purposes.– In general, gain is not recognized until property is sold.
• Deferring recognition of gain on investments such as stock or bonds can be accomplished using a buy and hold strategy.– Gain is not recognized until the bond or security is sold.– When stocks or bonds are sold, gain can be minimized by selling
stocks or bonds with the highest basis relative to sales price.• In the same year, stocks or bonds might also be sold at a loss to
offset the gain.
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 5
Timing of Capital Gain or Loss
• Accelerating recognition of loss on investments such as stock or bonds can be accomplished by selling the stock or bond.– The recognition of a loss may not be allowed currently where
the sale is between certain related persons, or where the investor holds or acquires certain other positions in the property being sold at a loss.
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 6
Timing of Capital Gain or Loss
• Certain tangible property can be exchanged for other property in a like-kind exchange.– Defer the taxation that would otherwise have occurred upon
disposition of the first property until the like-kind property is sold.
– Available to real estate, life insurance, and annuities
• Gain on sale of property may also be deferred through installment sales and private annuities.
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 7
Mutual Funds
• Mutual funds with different tax characteristics– One factor to be considered during selection is the expected
tax treatment of distributions from the fund.– Sale by the investor of shares in the mutual fund is generally a
taxable event.
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 8
Mutual Funds
• Investor in a mutual fund is taxed the same as if the investor invested in the investments owned by the mutual fund.– If the investor wants long-term capital gains, he/she might
choose a fund that invests in stocks with tax management.• Emphasizes minimizing current taxation by avoiding
interest, dividends, and realized capital gains.• The turnover ratio for a fund’s assets may be useful in
determining how well a fund minimizes or postpones capital gain recognition.
Tax-Efficient Investment Strategies
Chapter 44Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 9
Mutual Funds
• Different treatment generally applies when an Individual Retirement Account (IRA) or retirement plan is invested in a mutual fund.– Taxation is generally deferred until distributions are made from the IRA
or retirement plan.– An IRA owner or retirement plan investor can have distributions
reinvested in the mutual fund and there is no current taxation of such reinvested distributions.
– He/she can also rollover the IRA or retirement account to another mutual fund without being taxed on the rollover.
– All distributions from the IRA or retirement account are generally taxed at ordinary income tax rates.
• Trade-off between the tax benefits of an IRA or qualified plan and the forgoing of special capital gain or qualified dividend treatment.