TAXES AND PRIVATE WEALTH MANAGEMENT in a global context Individual Investors R-10 (SS-4)

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Sources of taxes: o Taxes on income: ordinary (salaries) or investment income (interest, dividends, realized and

unrealized capital gains). o Wealth-based taxes: holding certain property (real estate), transfer of wealth, or aggregate assets

above a certain threshold. o Taxes on consumption: include sales taxes and VAT.

Progressive vs. flat tax structure – average vs. marginal tax rate.

General income tax regimes:

Tax regime Tax structure Y: favorable or exempt, N: ordinary

Interest Dividend Capital gains

Common progressive (most common) Progressive Y Y Y

Heavy dividend Progressive Y N Y

Heavy capital gain (least common) Progressive Y Y N

Heavy interest Progressive N Y Y

Light capital gain (second most common) Progressive N N Y

Flat & light Flat Y Y Y

Flat & heavy Flat Y N N

Types of taxes: o Simple tax environment:

Returns-based taxes: Accrual taxes: levied on interest and dividend on an annual basis. Most common with bonds and preferred stock.

( ( ))

Tax drag $ = FV with t=0 – FV after taxes

Tax drag % = Tax drag $ / Return with t=0 (FV with t=0 – initial investment)

Tax drag % > t, as tax drag compounds overtime when taxes are paid annually.

↑ Investment horizon ⇒ ↑ TD$, ↑ TD% — ↑ Return ⇒ ↑ TD$, ↑ TD% Returns-based taxes: Deferred capital gains: deferred until realized. Most common with

shares.

Tax drag % = t, as tax drag doesn’t compound overtime.

Investment horizon and return are not related to TD$ & TD% ⇒ ↑ relative value of deferred taxes as compared to accrual taxes.

B = Cost basis / current market value. For new investments cost basis usually equals market value ⇒ B = 1. For historical investments, B < 1 means that a portion of investment (1-B) represents unrealized gain and should be taxed at exit.

Wealth-based taxes: annual usually low rate as applies to both principal and return.

Tax drag % > t.

↑ Investment horizon ⇒ ↑ TD$, ↑ TD% — ↑ Return ⇒ ↑ TD$, TD% (as wealth tax is less sensitive to return)

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TAXES AND PRIVATE WEALTH MANAGEMENT in a global context Individual Investors R-10 (SS-4)

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o Blended tax environment:

Increase in investment value = Interest (I) + Dividend (d) + realized capital gain (CG) + unrealized capital gain (deferred till exit).

Realized tax rate = Return after realized taxes (RART) =

Effective capital gain tax rate (TEGC) = (

)

Accounts for taxes on the previously non-taxed unrealized capital gains. [

]

Accrual equivalent after tax return (RAE) = (

)

Required return from tax-free investment (or geometric average return over period n) < RART as it accounts for deferred taxes on unrealized capital gains to be realized at the end of investment horizon.

RAE – R = tax drag, RAE R as n increases, due to the increase in deferral value.

Accrual equivalent tax rate (TAE) = (

)

Less TAE is more tax efficient.

TAE as B ↑.

TAE as n ↑ as the value of deferral increases ⇒ TAE may be less than tax rate.

Types of investment accounts: o Taxable account. o Tax deferred account (TDA): front-end tax benefit (non-taxable contributions and taxed at exit)

⇒ same as deferred capital gains with B=0.

o Tax exempt account (TEA): back-end tax benefit (taxable contributions, non-taxed at exit)

o ⇒ if tf < t0 ⇒ TDAFV > TEAFV

Asset allocations should be considered after tax effect.

Investors after tax risk measured in standard deviation = . Government share in risk if all losses are tax deductible in same year.

Tax : consider asset characteristics in asset location (i.e. equities in taxable accounts, bonds in tax advantaged accounts).

Tax implication of trading behavior: o Traders: high turnover ⇒ accrual taxed on ordinary rate. o Active investors: less turnover ⇒ accrual taxed on long-term rate. o Passive investors: low turnover ⇒ deferred taxed. o Exempt investors: no taxes o ⇒ the importance of holding period management on after tax wealth accumulation.

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TAXES AND PRIVATE WEALTH MANAGEMENT in a global context Individual Investors R-10 (SS-4)

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Tax loss harvesting: match losses with gains to decrease taxes or defer it, by increasing net of tax capital invested in the portfolio. Equity investment has the most potential for creating tax due to its volatile prices (accordingly, cost basis).

Tax lot accounting: o If tax rate is expected to decrease ⇒ HIFO (Highest B means lowest gain). o If tax rate is expected to increase ⇒ LIFO (Lowest B means highest gain).

Mean-Variance optimization process should be based on an efficient frontier consisting of portfolios on an after tax basis. In its determination substitute accrual equivalent after tax returns for before tax returns, and tax-adjusted risk for before tax risk.

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ESTATE PLANNING in a global context Individual Investors R-11 (SS-4)

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Estate planning: transferring assets during life or at death in the most efficient way, usually outside the complex probate process.

o Will (testament) — testator o Gifts (donor-recipient): life-time gratuitous transfer. o Bequests (testator-beneficiary): testamentary (after death) gratuitous transfer.

Regulations: o Civil law: based on Roman law (Foundations) — restricted disposition by will — top-down system. o Common law: based on English law (Trusts) — freedom of disposition by will — bottom-up system. o Forced heirship rules: separate property regime (common in civil law) vs. community (½ spouses).

Spouse take the higher of ½ * community property or forced heirship % * Total estate. Reduce gifts to charity before applying claw-back provisions. Clawback provisions bring life

time gifts back into the estate to calculate child’s share. o Taxes on wealth transfer may be applied to the transferor (against the estate) or the recipient

(inheritance tax). The tax structure may be flat or progressive and usually after deduction of a statutory allowance.

Core capital and excess capital: o Core capital: needed for living expenses to maintain a given lifestyle

Sum of expected annual spending present value over life expectancy. Survival probability: joint probability (either A or B will survive) = P(A) + P(B) – (P(A) * P(B))

Discount real spending using real interest rate or nominal spending using nominal rate.

Real risk-free rate:

Monte-Carlo simulation:

For each spending rate, gives the ruin probability, which is the probability of depleting one’s assets before death (longevity risk). The goal is to select the highest spending rate that has acceptable ruin probability.

⁄

o Excess capital: Total assets (with net employment (human) capital) – Core capital – Safety reserve

Estate planning strategies: o Tax reduction through gift instead of bequest

( ( ))

( )

* [( ) if taxable, recipient OR ( ) if taxable, donor]

o Generation skipping: avoid double taxation with the benefit (relative value) of ( ⁄ ).

o Spousal exemptions: if transfer is tax free, then gift to next generation directly is better than transferring full estate to the living spouse.

o Valuation discounts: decrease tax — decrease as value increase — lack of liquidity and minority interest (lack of control) discounts are not additive.

o Charitable gifts relative value:

( ) ( )

( )

Interpretation: by gifting assets to charity now, they are worth (x) times than if bequested to a beneficiary who then donates them in (n) years.

o Deemed dispositions: bequest as sold ⇒ levy tax only on the portion of unrealized gains, if any.

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ESTATE PLANNING in a global context Individual Investors R-11 (SS-4)

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Estate planning tools: o Trusts: grantor (settlor) trustee (manager)

Recoverable trust: settlor is the legal owner for reporting, taxation and can be claimed. Irrecoverable trust: trustee is the owner for tax purposes, with no claim on assets. Fixed trust: distribution is predetermined by the settlor. Discretionary trust: trustee determines distribution — settlor can use “letter of wishes” —

beneficiaries have no legal right over assets, thus claims against them can’t be applied against trust assets.

Spendthrift trust: beneficiary too young, assets transfer outside probate while settlor has some control over assets distribution.

Advantages: control – avoidance of probate – asset protection – tax reduction. Trusts are legal relationships according to common law.

o Foundations: Similar to trusts. Legal persons according to civil law.

o Life insurance: Proceeds pass to beneficiaries without tax consequences. Can be used in conjunction with trust, by making the trust as the beneficiary, thus efficiently

transfer assets outside the probate process. o Controlled Foreign Corporations (CFC):

Tax on earnings of the company may be deferred until either the earnings are actually distributed to shareholders or the company is sold.

Deemed distribution: pay tax on company earnings even if no actual distribution had been made.

Relief from double taxation: o Tax jurisdiction:

Source jurisdiction: inside borders, territorial tax system (income tax) Residence jurisdiction: domestic and foreign sourced. Deemed disposition: exit taxes on transfers based on gains as if the individual sold them.

May last for a period (shadow period) following expatriation. o Double taxation treaties (DTT – Hauge conference):

Residence-residence conflicts Organization for economic cooperation and development (OECD) recognizes “tie breakers”

as: home – center of vital interest – citizenship, with no obvious resolution for source-source conflicts.

Resolutions for residence-source conflicts: (always source (foreign) takes full tax)

Credit method: pay the higher. Source receives its part and the remaining, if any, to residence.

Exemption method: only pay for foreign — rare method.

Deduction method: Pay Tsource to Source, and pay Tresidence * (1 – Tsource) to residence. International transparency in setting DTTs —countries try to maximize taxes paid through

exchange of info. Qualified intermediary (QI): to avoid disclosing the names of all their customers, provide info. on the required customers only.

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CONCENTRATED SINGLE ASSET POSITIONS Individual Investors R-12 (SS-5)

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LIFETIME FINANCIAL ADVICE: HC, Asset Allocation, and Insurance Individual Investors R-13 (SS-5)

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For economic purposes, human life can be segregated into 3 phases; the preparation, the accumulation, and retirement. Investment decisions are made within the last two stages.

Accumulation phase: o Human capital at a particular time equals the future labor income discounted at an appropriate rate

(Risk-free + risk premium). Doesn’t vanish post retirement because of social security and DB payments.

Should be considered as a separate asset class from a total portfolio management perspective, accordingly, its characteristics (size and risk) affects optimal asset allocation.

Size:

Decrease by time in favor of increasing financial capital. This should be reflected on asset allocation by increasing stocks at early years to be scaled back gradually.

Increase in initial wealth decreases the portion of human capital to total financial wealth; accordingly, allocation to risk-free assets should be increased.

Risk:

High volatility and correlation with equity market entails that more allocation to fixed income investments is needed (e.g. broker), and vice versa (e.g. teacher).

Correlation between human capital and financial capital should be minimized. (e.g. diversify holdings of own firm’s or its industry stocks).

o Mortality risk: premature death, accordingly, sudden loss of human capital. Can be hedged by life insurance (ρ = -1). Factors affecting demand for life insurance:

Human Capital volatility (-), Financial Capital and initial wealth (-), Risk aversion (+), Probability of death (+), and Relative strength of the utility of bequest (+)

Utility of bequest and probability of death has no effect on optimal asset allocation. The decisions as to how much life insurance is needed and how to allocate financial

resources between risk-free (bondlike) and risky (stocklike) assets, should be analyze jointly within the dynamics of human capital.

Retirement phase: o Risks:

Financial market risk: dependence on systematic withdrawals assuming constant returns (i.e. zero market volatility) has a major shortfall risk. Could be mitigated through modern portfolio theory (mean-variance optimization process).

Savings risk (spending uncertainty): people tend to consume currently over saving for future consumption. No direct remedy is available as the root cause is behavioral.

Longevity risk: outlive one’s assets. The proportion of social security and DB payments is decreasing in favor of savings and DC payments.

o Retirement planning: Can be done through lifetime payout annuity which is a form of insurance (annuitized asset)

or systematic withdrawals (non-annuitized asset). Combining both provides retirement income protection and manages financial market & longevity risks.

Lifetime payout annuities are mainly classified as:

Fixed: disadvantages: nominal payments rather than real – based on current interest rates, which may prove to be low compared to future – illiquid

Variable: based on performance of underlying fund selected by investor, hedge against inflation, with the risk of shortfall (not meeting spending objective).

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