“TAX CONSIDERATIONS IN INVESTING,” CH. 8, ROBERT H. JEFFREY, THE PO...

2. “Tax Considerations in Investing,” Ch. 8, Robert H. Jeffrey, The Portable MBA in

Investment, Peter L. Bernstein, ed. (John Wiley & Sons, 1995)

Purpose:

To test the candidate’s understanding of how tax and mutual fund considerations affect investment

returns and investment strategies.

LOS: The candidate should be able to

“Mutual Fund Misclassification: Evidence Based on Style Analysis” (Session 11)

• discuss why a mutual fund could be misclassified in regard to its investment guidelines.

“Tax Considerations in Investing” (Session 13)

• explain the importance of taxation on investment policy and discuss taxes as an investment

expense;

• differentiate capital gains and dividends and compare the taxation of each;

• analyze the impact of turnover on the portfolio when taxes are considered and calculate the

effect of turnover at a given tax rate;

• analyze the profile of an individual investor, discuss the impact of spending requirements on

overall investment performance, discuss the probability of realizing capital gains taxes, and

discuss the benefits of deferring capital gains taxes;

• discuss the advantages and disadvantages of realizing losses.

Guideline Answer:

A. Compared to the Superior Growth and Income Fund, the Exceptional Growth and Income Fund

is more consistent with the Muellers’ goal with regard to both the return volatility and the

expected one-year after-tax return.

i. Return Volatility. The Exceptional Fund has had a substantially lower beta than the Superior

Fund. Based on the betas, Exceptional has been slightly less volatile than the overall market

while Superior has been considerably more volatile than average. Exceptional has also

exhibited more consistent performance in the past, producing a lower return in up markets

and a higher return in down markets.

ii. Expected One-Year After-Tax Return (assuming all turnover resulted in gains). The

Exceptional Fund’s expected one-year after-tax return is 9.73 percent and the Superior

Fund’s comparable return is 9.50 percent. Each fund’s gross (pre-tax) total return is

composed of the fund’s capital appreciation and dividend yield. The gross appreciation rate

is the expected realized capital gains (estimated by the fund’s turnover rate) taxed at the

client’s capital gains tax rate (20% in the case of the Muellers). The gross dividend return is

reduced by the client’s applicable ordinary income tax rate (30% for the Muellers). The

expected after-tax return can be estimated by:

= taxed capital gain + taxed dividend yield + non-taxed capital gain

OR

= [(total return – yield) × (turnover rate) × (1 – capital gains tax rate)]

+ [yield × (1 – income tax rate)] + [(total return – yield) × (1 – turnover rate)]

= (total return – yield) × (1 – turnover rate × capital gains tax rate)

+ [yield × (1 – income tax rate)]

= total return – (yield × ordinary tax rate) – [(total return – yield) × turnover × capital

gains tax rate]

The Exceptional Fund’s expected after-tax return is:

= [(0.105 – 0.02) × (1 – 0.10 × 0.20)] + [0.02 × (1 – 0.30)]

= [0.085 × (1 – 0.02)] + [0.02 × 0.70]

= [0.085 × 0.98] + 0.014

= 0.0833 + 0.014

= 0.0973, or 9.73%

The Superior Fund’s expected after-tax return is:

= [(0.11 – 0.01) × (1 – 0.60 × 0.20)] + [0.01 × (1 – 0.30)]

= [0.10 × (1 – 0.12)] + [0.01 × 0.70]

= [0.10 × 0.88] + 0.007

= 0.088 + 0.007

= 0.095, or 9.50%

B. Realized losses can add value to a portfolio. Realized losses can be used as a direct offset to

capital gains already realized or to those to be realized in the future. In effect, realized losses can

be exchanged for monies that would otherwise be paid to the taxing authority, creating

additional “cash in the bank”. The greatest tax benefit and addition to portfolio value is likely to

occur if losses are realized whenever they are available rather than waiting until the end of a tax

year to sell any losers. Obviously, realizing losses can add to the value of a portfolio only as

long as the tax benefit is greater than the trading costs that are incurred. Otherwise, realizing tax

losses does have a negative effect on portfolio value.

Level III: Question 5

Topic: Investment Policy Statement

Minutes: 12

Reading References: