Discussion Questions

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I:18-1

Chapter I:18

Taxes and Investment Planning

Discussion Questions

I:18-1 The primary distinguishing feature that causes the Current, Deferred, and Pension Models to differ is the timing of taxation. With the Current Model, after-tax dollars are invested, and the investment earnings are taxed currently. With the Deferred Model, after-tax dollars are invested, but the investment earnings are taxed at the end of the investment horizon. With the Pension Model, before-tax dollars are invested, and both the contributed dollars and the investment earnings are taxed at the end of the investment horizon. Thus, the Current Model provides no deferred taxation, the Deferred Model provides one level of deferred taxation (on earnings), and the Pension Model provides two levels of deferred taxation (on contributed dollars and earnings).pp. I:18-2, I:18-5, and I:18-10 (page numbers where discussion of each model begins).

I:18-2 The annualized after-tax rate of return (ATROR) is the rate of return that would cause an investment conforming to the Current Model to yield the same accumulation per after-tax dollar invested as the investment under consideration. It is similar to the internal rate of return of the investment. The annualized ATROR is useful because it allows the planner to compare various kinds of investments without knowing the exact amount that he or she will invest. That is, it allows comparison of rates of returns rather than accumulated dollars. pp. I:18-7 and I:18-8.

I:18-3 The before-tax rate of return (BTROR) of the capital asset may be lower than the BTROR on a fully-taxable investment because the capital asset’s return may reflect implicit taxes. Nevertheless, the capital asset may be preferable because the benefit of deferred taxation will outweigh the reduced rate of return if the investment horizon is long enough. pp. I:18-8, I:18-24, and I:18-25.

I:18-4 A taxpayer trying to decide between saving outside an IRA or through a traditional IRA should not necessarily avoid the IRA even if the withdrawal from the IRA would trigger the 10% early withdrawal penalty. The benefit of deferred taxation of the traditional IRA will outweigh the penalty if the investment horizon is long enough. On the other hand, a taxpayer who plans to make an early withdrawal may want to consider the Roth IRA because withdrawals from a Roth IRA are deemed first from contributions (Chapter I:7). Thus, Roth IRA withdrawals that do not exceed prior contributions are exempt from taxation and are not subject to the 10% early withdrawal penalty even though the withdrawals are not qualified distributions. pp. I:18-8

through I:18-14.

I:18-5 It increases over time. Unlike the Current Model, which has a constant annualized after- tax rate of return (ATROR) regardless of the investment horizon, the Deferred Model’s annualized ATROR increases as the investment horizon increases. That is, r ann increases as n increases, assuming a constant before-tax rate of return (BTROR). This result occurs because the tax deferral benefit increases as the investment horizon increases. pp. I:18-7 and I:18-8.

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I:18-2

I:18-6 Equivalent if t

• = tn; not equivalent if t0 ≠ tn. That is, the Exempt and Pension Models are

equivalent if the tax rate in the contribution year (t 0) equals the tax rate in the withdrawal year (t n), assuming the contribution to each in before-tax dollars is the same and before-tax rates of return are the same. The equivalence breaks down, however, when t

• and tn are not equal. The

Exempt Model is better than the Pension Model if tax rates are increasing (i.e., t

• < tn).

Conversely, the Pension Model is better than the Exempt Model if tax rates are decreasing (i.e., t

• > tn). The $7,000 limitation (for 2025) affects the comparison of a traditional deductible IRA

(Pension Model) and a Roth IRA (Exempt Model) because the $7,000 maximum contribution to a deductible IRA is deductible (i.e., is before-tax dollars) while the $7,000 maximum contribution to a Roth is not deductible (i.e., is after-tax dollars). To properly compare these two vehicles, the analyst must determine the after-tax accumulation resulting from investing the tax savings from the deductible contribution. This amount must be added to the deductible IRA accumulation so that the total accumulation can be compared with the accumulation from the Roth IRA. pp. I:18-12 through I:18-14.

I:18-7 Deferral of shareholder tax. The C corporation entails two levels of taxation, one at the corporate level and another at the shareholder level. Assuming no current distributions (i.e., dividends), the shareholder’s tax is deferred until the shareholder sells the stock or until the corporation liquidates. This deferred taxation is captured in the Deferred Model. pp. I:18-21 and

I:18-22.

I:18-8 A key factor in the Roth conversion decision is the tax rate structure. A low tax rate at the time of conversion compared to a high tax rate at the time of withdrawal would sway the decision toward converting to the Roth. In this case, the conversion tax would be at a relatively low tax rate while distributions from the Roth IRA would avoid being taxed at a high tax rate.Other factors also come into play, such as rates of return and the source of paying the conversion

tax. p. I:18-19.

I:18-9 The tax rates facing individual entity owners versus the 21% C corporation tax rate are key factors. Also important is the qualified business income (QBI) deduction available to pass-through entity owners. The QBI deduction effectively reduces the owner’s tax rate by a factor of 20%. The 100% Sec. 1202 exclusion, if applicable, plays an important role as well because it reduces the C corporation shareholder’s tax rate to zero upon the sale of the corporate stock. pp. I:18-22 through

I:18-24.

I:18-10 Implicit taxes. An investment conforming to the Exempt Model may have a lower before- tax rate of return (BTROR) than does a risk-equivalent investment conforming to the Current Model because of implicit taxes. See the solution for Discussion Question I:18-11 for a discussion of the process that leads to implicit taxes. pp. I:18-24 through I:18-27.

I:18-11 An implicit tax is the reduced before-tax rate of return (BTROR) on a tax-favored investment compared to the BTROR on a risk-equivalent fully taxable benchmark investment.The implicit tax is defined as IT = R b − Re, where Rb is the risk-adjusted BTROR on the benchmark investment, and R e is the BTROR on the tax-favored investment. Investor demand for the tax-favored investment will drive up its price and drive down its BTROR until after-tax rates of return (ATRORs) are equal for the marginal investors. This reduced BTROR is an implicit tax. pp. I:18-24 through I:18-27.

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