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18-1 ©2009 Pearson Education, Inc. Publishing as Prentice Hall
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18-1©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-2
TAXES AND INVESTMENT TAXES AND INVESTMENT PLANNINGPLANNING
Investment modelsOther applications of
investment modelsImplicit taxes and clienteles
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-3
Investment ModelsInvestment Models
The current modelThe deferred modelThe exempt modelThe pension modelMultiperiod strategies
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-4
The Current Model(1 of 2)
Only after-tax dollars investedEarnings on investment taxed
currentlyReinvested earnings grow at after-
tax rate of return
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-5
The Current Model(2 of 2)
ATA = AT$ x [1 + R(1-t)]n
ATA – After-tax accumulationAT$ – After-tax dollarsR – Before tax rate of return
R(1-t) After-tax rate of returnt – Marginal tax raten – Number of years
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-6
The Deferred Model(1 of 3)
Only after-tax dollars investedEarnings on investment not taxed
currentlyThey grow at before tax rate of return
Accumulated earnings taxed at end of investment horizonWhen investor cashes out investment
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-7
The Deferred Model(2 of 3)
ATA = AT$ x [(1 + R)n x (1-tn) + tn]
ATA – After-tax accumulationAT$ – After-tax dollarsR – Before tax rate of returnt – Marginal tax raten – Number of years
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-8
The Deferred Model(3 of 3)
ExamplesNondeductible IRA contributionsRoth IRA contributionsAfter-tax growth of a capital asset
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-9
The Exempt Model(1 of 3)
Only after-tax dollars investedEarnings on investment exempt
from explicit taxationSpecial case of current or
deferred model with tax rate = 0%
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-10
The Exempt Model(2 of 3)
ATA = AT$ x (1 + R)n
ATA – After-tax accumulationAT$ – After-tax dollarsR – Before tax rate of returnn – Number of years
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-11
The Exempt Model(3 of 3)
ExamplesRoth IRA contributionRoth option for §401(k) and
§403(b) plans
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-12
The Pension Model(1 of 3)
Before-tax dollars investedAnnual earnings on investment
grow at before tax rate of returnEntire accumulation taxed at
end of investment horizon
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18-13
The Pension Model(2 of 3)
ATA = BT$ x (1 + R)n x (1-tn) ATA – After-tax accumulationAT$ – After-tax dollarsR – Before tax rate of returnt – Marginal tax raten – Number of years
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-14
The Pension Model(3 of 3)
Deductible IRA contribution§401(k) and §403(b) plans
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-15
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 Hall
18-16
Other Applications of Other Applications of Investment ModelsInvestment Models Pass-Through vs. C CorporationPass-Through vs. C Corporation (1 of 2) (1 of 2)
Assume S corp or C corp with 1 shareholder
Pass-through modelATA = contribution x [1 + Rf (1-
tp)]n
Rf – Before tax rate of returntp – Owner’s marginal tax raten – Number of years
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-17
Other Applications of Other Applications of Investment ModelsInvestment Models Pass-Through vs. C Corporation (2 of 2)Pass-Through vs. C Corporation (2 of 2)
C corporation modelATA = contrib x [(1 + rc)n – (1-
tp) + tp]
contrib – Capital contributionrc – Before tax rate of returntp – Owner’s marginal tax rate
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-18
Other Applications of Other Applications of Investment ModelsInvestment Models
Current Salary vs. Deferred Comp (1 of 4)Current Salary vs. Deferred Comp (1 of 4)
Employee’s point of viewCurrent salary
Pay taxes currentlyInvest after-tax dollars
Deferred salaryPay tax in year of receiptInvest before-tax dollars
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-19
Other Applications of Other Applications of Investment ModelsInvestment Models
Current Salary vs. Deferred Comp (2 of 4)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 incomeDCI – Deferred compensation incomeDn – $ Def comp in lieu of $1 current saltpo – Employee’s marginal tax rate in yr 0tpn – Employee’s marginal tax rate in yr n
©2009 Pearson Education, Inc. Publishing as Prentice Hall
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Other Applications of Other Applications of Investment ModelsInvestment Models
Current Salary vs. Deferred Comp (3 of 4)Current Salary vs. Deferred Comp (3 of 4)
Employer’s point of viewCurrent salary
Immediate tax benefitSalary less tax benefit is employers after-
tax salary expenseDeferred salary
Have after-tax salary expense available for investment until time n when deferred compensation is paid
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-21
Other Applications of Other Applications of Investment ModelsInvestment Models
Current Salary vs. Deferred Comp (4 of 4)Current Salary vs. Deferred Comp (4 of 4)
Employer’s point of view (continued)CSE = BT$ x (1 + tco) x (1-rc)n
DCE = BT$ x (Dn) x (1-tcn)CSE – Current salary expenseDCE – Deferred compensation expensetco – Employer’s marginal tax rate in yr 0
tcn – Employer’s marginal tax rate in yr n
©2009 Pearson Education, Inc. Publishing as Prentice Hall
18-22
Implicit Taxes and Implicit Taxes and ClientelesClienteles
Implicit taxesMarket adjustments for tax-favored
investmentsDifference in before tax rates of
return between a nontax-favored investment and a tax-favored investmentAssumes similar risk and duration
©2009 Pearson Education, Inc. Publishing as Prentice Hall
Comments or questions about PowerPoint Slides?Contact Dr. Richard Newmark at University of Northern Colorado’s
Kenneth W. Monfort College of [email protected]
18-23©2009 Pearson Education, Inc. Publishing as Prentice Hall
