1. 18-1 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

2. 18-2 TAXES AND INVESTMENT PLANNING Investment models Other applications of investment models Implicit taxes and clienteles ©2009 Pearson Education, Inc. Publishing as Prentice Hall

3. 18-3 Investment Models The current model The deferred model The exempt model The pension model Multiperiod strategies ©2009 Pearson Education, Inc. Publishing as Prentice Hall

4. 18-4 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

5. 18-5 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

6. 18-6 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

7. 18-7 The Deferred Model (2 of 3) ATA = AT$ x [(1 + R) n x (1-t n ) + t n ] ATA – After-tax accumulation AT$ – After-tax dollars R – Before tax rate of return t – Marginal tax rate n – Number of years ©2009 Pearson Education, Inc. Publishing as Prentice Hall

8. 18-8 The Deferred Model (3 of 3) Examples Nondeductible IRA contributions Roth IRA contributions After-tax growth of a capital asset ©2009 Pearson Education, Inc. Publishing as Prentice Hall

9. 18-9 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% ©2009 Pearson Education, Inc. Publishing as Prentice Hall

10. 18-10 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

11. 18-11 The Exempt Model (3 of 3) Examples Roth IRA contribution Roth option for §401(k) and §403(b) plans ©2009 Pearson Education, Inc. Publishing as Prentice Hall

12. 18-12 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

13. 18-13 The Pension Model (2 of 3) ATA = BT$ x (1 + R) n x (1-t n ) ATA – After-tax accumulation AT$ – After-tax dollars R – Before tax rate of return t – Marginal tax rate n – Number of years ©2009 Pearson Education, Inc. Publishing as Prentice Hall

14. 18-14 The Pension Model (3 of 3) Deductible IRA contribution §401(k) and §403(b) plans ©2009 Pearson Education, Inc. Publishing as Prentice Hall

15. 18-15 Multiperiod Strategies Models assume single amount invested for a certain period of time For periodic investments an investor may optimize his/her after-tax accumulation by investing in 1 type of investment early years and another in later years ©2009 Pearson Education, Inc. Publishing as Prentice Hall

16. 18-16 Other Applications of Investment Models Pass-Through vs. C Corporation (1 of 2) Assume S corp or C corp with 1 shareholder Pass-through model ATA = contribution x [1 + R f (1-t p )] n R f – Before tax rate of return t p – Owners marginal tax rate n – Number of years ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17. 18-17 Other Applications of Investment Models Pass-Through vs. C Corporation (2 of 2) C corporation model ATA = contrib x [(1 + r c ) n – (1-t p ) + t p ] contrib – Capital contribution r c – Before tax rate of return t p – Owners marginal tax rate ©2009 Pearson Education, Inc. Publishing as Prentice Hall

18. 18-18 Other Applications of Investment Models Current Salary vs. Deferred Comp (1 of 4) Employees point of view Current salary Pay taxes currently Invest after-tax dollars Deferred salary Pay tax in year of receipt Invest before-tax dollars ©2009 Pearson Education, Inc. Publishing as Prentice Hall

19. 18-19 Other Applications of Investment Models Current Salary vs. Deferred Comp (2 of 4) Employees point of view (continued) CSI = BT$ x (1 + t po ) x (1-r p ) n DCI = BT$ x (D n ) x (1-t pn ) CSI – Current salary income DCI – Deferred compensation income D n – $ Def comp in lieu of $1 current sal t po – Employees marginal tax rate in yr 0 t pn – Employees marginal tax rate in yr n ©2009 Pearson Education, Inc. Publishing as Prentice Hall

20. 18-20 Other Applications of Investment Models Current Salary vs. Deferred Comp (3 of 4) Employers 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

21. 18-21 Other Applications of Investment Models Current Salary vs. Deferred Comp (4 of 4) Employers point of view (continued) CSE = BT$ x (1 + t co ) x (1-r c ) n DCE = BT$ x (D n ) x (1-t cn ) CSE – Current salary expense DCE – Deferred compensation expense t co – Employers marginal tax rate in yr 0 t cn – Employers marginal tax rate in yr n ©2009 Pearson Education, Inc. Publishing as Prentice Hall

22. 18-22 Implicit Taxes and Clienteles Implicit taxes 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

23. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorados Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 18-23 ©2009 Pearson Education, Inc. Publishing as Prentice Hall