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2. TAXES AND INVESTMENT PLANNING
Investment models
Other applications of investment models
Implicit taxes and clienteles
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3. Investment Models The current model The deferred model
The exempt model
The pension model
Multiperiod strategies
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4. The Current Model (1 of 2) Only after-tax dollars invested
Earnings on investment taxed currently
Reinvested earnings grow at after-tax rate of return
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5. The Current Model (2 of 2) ATA = AT$ x [1 + R(1-t)]n
ATA – After-tax accumulation
AT$ – After-tax dollars
R – Before tax rate of return
R(1-t) After-tax rate of return
t – Marginal tax rate
n – Number of years
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6. The Deferred Model (1 of 3)
Only after-tax dollars invested
Earnings on investment not taxed currently
They grow at before tax rate of return
Accumulated earnings taxed at end of investment horizon
When investor cashes out investment
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7. The Deferred Model (2 of 3)
ATA = AT$ x [(1 + R)n x (1-tn) + tn]
ATA – After-tax accumulation
AT$ – After-tax dollars
R – Before tax rate of return
t – Marginal tax rate
n – Number of years
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8. The Deferred Model (3 of 3)
Examples
Nondeductible IRA contributions
Roth IRA contributions
After-tax growth of a capital asset
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9. The Exempt Model (1 of 3) Only after-tax dollars invested
Earnings on investment exempt from explicit taxation
Special case of current or deferred model with tax rate =0%
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10. The Exempt Model (2 of 3) ATA = AT$ x (1 + R)n
ATA – After-tax accumulation
AT$ – After-tax dollars
R – Before tax rate of return
n – Number of years
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11. The Exempt Model (3 of 3) Examples Roth IRA contribution
Roth option for §401(k) and §403(b) plans
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12. The Pension Model (1 of 3) Before-tax dollars invested
Annual earnings on investment grow at before tax rate of return
Entire accumulation taxed at end of investment horizon
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13. The Pension Model (2 of 3) ATA = BT$ x (1 + R)n x (1-tn)
ATA – After-tax accumulation
AT$ – After-tax dollars
R – Before tax rate of return
t – Marginal tax rate
n – Number of years
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14. The Pension Model (3 of 3) Deductible IRA contribution
§401(k) and §403(b) plans
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15. Multiperiod Strategies
Models assume single amount invested for a certain period of time
For periodic investments an investor may optimize her after-tax accumulation by investing in one type of investment early years and another in later years
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16. Other Applications of Investment Models Flow-Through vs
Other Applications of Investment Models Flow-Through vs. C Corporation (1 of 2)
Assume S corp or C corp with one shareholder
Flow-through model
ATA = contribution x [1 + Rf (1-tp)]n
Rf – Before tax rate of return
tp – Owner’s marginal tax rate
n – Number of years
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17. Other Applications of Investment Models Flow-Through vs
Other Applications of Investment Models Flow-Through vs. C Corporation (2 of 2)
C corporation model
ATA = contrib x [(1 + rc)n – (1-tp) + tp]
rc – Before tax rate of return
tp – Owner’s marginal tax rate
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18. Other Applications of Investment Models Current Salary vs
Other Applications of Investment Models Current Salary vs. Deferred Comp (1 of 4)
Employee’s point of view
Current salary
Pay taxes currently
Invest after-tax dollars
Deferred salary
Pay tax in year of receipt
Invest before-tax dollars
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19. Other Applications of Investment Models Current Salary vs
Other Applications of Investment Models Current Salary vs. Deferred Comp (2 of 4)
Employee’s point of view (continued)
CSI = BT$ x (1 + tpo) x (1-rp)n
DCI = BT$ x (Dn) x (1-tpn)
CSI – Current salary income
DCI – Deferred compensation income
Dn – $ Def comp in lieu of $1 current sal
tpo – Employee’s marginal tax rate in yr 0
tpn – Employee’s marginal tax rate in yr n
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20. Other Applications of Investment Models Current Salary vs
Other Applications of Investment Models Current Salary vs. Deferred Comp (3 of 4)
Employer’s point of view
Current salary
Immediate tax benefit
Salary less tax benefit is employers after-tax salary expense
Deferred salary
Have after-tax salary expense available for investment until time n when deferred compensation is paid
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21. Other Applications of Investment Models Current Salary vs
Other Applications of Investment Models Current Salary vs. Deferred Comp (4 of 4)
Employer’s point of view (continued)
CSE = BT$ x (1 + tco) x (1-rc)n
DCE = BT$ x (Dn) x (1-tcn)
CSE – Current salary expense
DCE – Deferred compensation expense
tco – Employer’s marginal tax rate in yr 0
tcn – Employer’s marginal tax rate in yr n
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22. Implicit Taxes and Clienteles
Market adjustments for tax-favored investments
Difference in before tax rates of return between a nontax-favored investment and a tax-favored investment
Assumes similar risk and duration
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23. ©2008 Prentice Hall, Inc.