Tax Planning, Basics of its Use

Objectives and Game Plan � Understand how deferral, deductibility & rate differences affect after-tax returns � Discuss key features of competing investment structures Assumptions � Same underlying security # Pre-tax return (R) = 7% � Tax rates constant across time & individuals # Tax rate on ordinary income (t) = 30% # Tax rate on capital gains (tg) = 15% � No frictions (transaction costs) � Certainty � $100 initial investment Savings Vehicles � Savings vehicles differ on three dimensions • Is the investment deductible? (yes / no) • Are earnings tax deferred? (yes / no) • What tax rates apply? (ordinary “t” / capital “tg” / exempt) Type I: Money Market (MM) � Other examples (savings accounts, corporate bonds, etc.) � Characteristics • No deduction • No deferral • Ordinary rates � Not “tax” advantaged Type I: Money Market (MM) � After-tax accumulation (ATA): ATA = [(1+R) - tR]n = [1+R(1-t)]n � After-tax rate of return: r = {[1+R(1-t)]n}1/n - 1 = R (1-t) � Observations: “r” does not depend on horizon Type II: Single Premium Deferred Annuity (SPDA) � Other example (non-deductible IRA) � Characteristics • No deduction • Deferral • Ordinary rates Type II: Single Premium Deferred Annuity (SPDA) � After-tax rate of return: r = {(1+R)n (1-t) + t}1/n - 1 � Observations: “r” grows with horizon because of deferral SPDA dominates MM if n>1 Type III: Mutual Fund With All Capital Gains � Assumes 100% turnover each year � Characteristics • No deduction • No deferral • Capital gains rates Type III: Mutual Fund With All Capital Gains � After-tax accumulation (ATA): ATA = [(1+R) - tgR]n = [1+R(1-tg)]n � After-tax rate of return: r = {[1+R (1-tg) ]n }1/n - 1 = R(1-tg) � Observations: Same as MM but replace “t” with “tg” “g” is inclusion factor, so tcg = tg (e.g. if tcg = 28% and t = 40% then g=0.28/0.40 = 0.70) If g < 1 dominates MM Type IV: Foreign Subsidiary � Other example (growth stock without dividends) � Characteristics • No deduction • Deferral • Capital gains rates Type IV: Foreign Subsidiary � After-tax accumulation (ATA): ATA= (1+R)n -[(1+R)n -1]tg = (1+R)n(1-tg) + tg � After-tax rate of return: r = {(1+R)n (1-tg) + tg}1/n - 1 � Observations: Same as SPDA but taxed at capital gains rate Dominates SPDA if g<1 Dominates III (mutual fund w/ all cg) if n>1 “r” grows with horizon because of deferral Type V: Insurance Policy or Tax Exempt Munis � Characteristics • No deduction • Permanent Deferral (Never taxed - assuming away the AMT) Type V: Insurance Policy or Tax Exempt Munis � After-tax accumulation (ATA): ATA = (1+R)n � After-tax rate of return: r = {(1+R)n}1/n - 1 = R � Observations: Dominates I through IV (Assuming pretax rate of return is the same across all assets. Ignores implicit taxes.) Type VI: Pension Fund or Deductible IRA � Characteristics • Deduction • Deferral • Ordinary rates Type VI: Pension Fund or Deductible IRA � IF to= tn � After-tax accumulation (ATA): ATA= 1 (1+R)n (1- tn) = (1+R)n 1-to � After-tax rate of return: r = { 1 (1+R)n(1- tn)}1/n - 1 1-to = (1+R) {(1-tn)/(1-to)}1/n - 1 = R Type VI: Pension Fund or Deductible IRA � Observations: # Equivalent to tax-exempt muni when to= tn # Government as partner allows you to invest 1/(1-to) but takes its cut at the end # Is comparison to munis fair in this case? Changes In Tax Rates Over Time � Tax exempt saving no longer equivalent to saving through a pension • If tax rates are rising over time, pensions and SPDAs become less attractive • If tax rates are falling, pensions and SPDAs become more attractive � How does time horizon affect your decisions regarding a pension investment? Ordinary tax rates � Individuals Maximum rate 2000 2001 2002 2003 39.6% 39.1% 38.6% 38.6% ....... � Corporations 0 - 50,000 50,000 - 75,000 75,000 - 100,000 100,000 - 335,000 335,000 - 10,000,000 10,000,000 - 15,000,000 15,000,000 - 18,333,333 >18,333,333 15% 25% 34% 39% 34% 35% 38% 35% Capital gains and losses � Short term < 1 year � Long term >1 year � Netting rules • Net short-term gains and losses and long-term gains and losses • If both are net gains or net losses, do no more netting • Otherwise net the two Individuals � Gains • Ordinary rates for short term capital gains (STCG) • Special rates for long term capital gains (LTCG), held > 12 months # After December 31, 2000 (generally) Maximum rate of 20% (10% if in 10 or 15% bracket) Special rate of 18% / 8% if held for more than 5 years # Prior law: maximum of 28% for LTCG Individuals � Losses • Can deduct up to $3,000 of net capital losses (investment property) per year • Net capital losses can be carried over indefinitely Corporations � No special tax rate for LTCG • (actually, there is, but it’s equal to 35%) � A corporation’s capital loss may only be used to offset capital gains � Get 3 year carryback and 5 year carryforward for NCL