2009 Pearson Education Inc Publishing as Prentice Hall
© 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 -1
TAXES AND INVESTMENT PLANNING ® Investment models ® Other applications of investment models ® Implicit taxes and clienteles © 2009 Pearson Education, Inc. Publishing as Prentice 18 -2
Investment Models ® The current model ® The deferred model ® The exempt model ® The pension model ® Multiperiod strategies © 2009 Pearson Education, Inc. Publishing as Prentice 18 -3
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 18 -4
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 18 -5
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 18 -6
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 © 2009 Pearson Education, Inc. Publishing as Prentice 18 -7
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 18 -8
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 18 -9
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 18 -10
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 18 -11
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 18 -12
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 © 2009 Pearson Education, Inc. Publishing as Prentice 18 -13
The Pension Model (3 of 3) ® Deductible IRA contribution ® § 401(k) and § 403(b) plans © 2009 Pearson Education, Inc. Publishing as Prentice 18 -14
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 18 -15
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 + Rf (1 -tp)]n ¬R f – Before tax rate of return ¬tp – Owner’s marginal tax rate ¬n – Number of years © 2009 Pearson Education, Inc. Publishing as Prentice 18 -16
Other Applications of Investment Models Pass-Through vs. C Corporation (2 of 2) ®C corporation model ATA = contrib x [(1 + rc)n – (1 -tp) + tp] ¬contrib – Capital contribution ¬rc – Before tax rate of return ¬tp – Owner’s marginal tax rate © 2009 Pearson Education, Inc. Publishing as Prentice 18 -17
Other Applications of Investment Models Current Salary vs. Deferred Comp (1 of 4) ® Employee’s Current point of view 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 18 -18
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 $1 current sal tpo – Employee’s marginal tax rate in yr 0 tpn – Employee’s marginal tax rate in yr n © 2009 Pearson Education, Inc. Publishing as Prentice 18 -19
Other Applications of Investment Models Current Salary vs. Deferred Comp (3 of 4) ® Employer’s Current point of view salary ¬Immediate tax benefit ¬Salary less tax benefit is employers aftertax salary expense Deferred salary ¬Have after-tax salary expense available for investment until time n when deferred compensation is paid © 2009 Pearson Education, Inc. Publishing as Prentice 18 -20
Other Applications of Investment Models Current Salary vs. Deferred Comp (4 of 4) ® Employer’s point of view (continued) CSE = BT$ 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 © 2009 Pearson Education, Inc. Publishing as Prentice 18 -21
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 18 -22
Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. newmark@Ph. Duh. com © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 -23
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