Slide 1TAXES AND INVESTMENT PLANNINGInvestment ModelsThe Current Model (1 of 2)The Current Model (2 of 2)The Deferred Model (1 of 3)The Deferred Model (2 of 3)The Deferred Model (3 of 3)The Exempt Model (1 of 3)The Exempt Model (2 of 3)The Exempt Model (3 of 3)The Pension Model (1 of 3)The Pension Model (2 of 3)The Pension Model (3 of 3)Multiperiod StrategiesOther Applications of Investment Models Flow-Through vs. C Corporation (1 of 2)Other Applications of Investment Models Flow-Through vs. C Corporation (2 of 2)Other Applications of Investment Models Current Salary vs. Deferred Comp (1 of 2)Other Applications of Investment Models Current Salary vs. Deferred Comp (2 of 2)Implicit Taxes and ClientelesSlide 2118-1©2007 Prentice Hall, Inc.©2007 Prentice Hall, Inc.18-2TAXES AND INVESTMENT TAXES AND INVESTMENT PLANNINGPLANNINGInvestment modelsOther applications of investment modelsImplicit taxes and clienteles©2007 Prentice Hall, Inc.18-3Investment ModelsInvestment ModelsThe current modelThe deferred modelThe exempt modelThe pension modelMultiperiod strategies©2007 Prentice Hall, Inc.18-4The Current Model(1 of 2)Only after-tax dollars investedEarnings on investment taxed currentlyReinvested earnings grow at after-tax rate of return©2007 Prentice Hall, Inc.18-5The 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©2007 Prentice Hall, Inc.18-6The 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©2007 Prentice Hall, Inc.18-7The 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©2007 Prentice Hall, Inc.18-8The Deferred Model(3 of 3)ExamplesNondeductible IRA contributionsRoth IRA contributionsAfter-tax growth of a capital asset©2007 Prentice Hall, Inc.18-9The 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%©2007 Prentice Hall, Inc.18-10The 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©2007 Prentice Hall, Inc.18-11The Exempt Model(3 of 3)ExamplesRoth IRA contributionRoth option for §401(k) and §403(b) plans©2007 Prentice Hall, Inc.18-12The 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©2007 Prentice Hall, Inc.18-13The 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n – Number of years©2007 Prentice Hall, Inc.18-14The Pension Model(3 of 3)Deductible IRA contribution§401(k) and §403(b) plans©2007 Prentice Hall, Inc.18-15Multiperiod StrategiesModels assume single amount invested for a certain period of timeFor periodic investments an investor may optimize her after-tax accumulation by investing in one type of investment early years and another in later years©2007 Prentice Hall, Inc.18-16Other Applications of Other Applications of Investment ModelsInvestment Models Flow- Flow-Through vs. C Corporation (1 of 2)Through vs. C Corporation (1 of 2)Assume S corp or C corp with one shareholderFlow-through modelATA = contribution x [1 + Rf (1-tp)]nRf – Before tax rate of returnTp – Owner’s marginal tax rate©2007 Prentice Hall, Inc.18-17Other Applications of Other Applications of Investment ModelsInvestment Models Flow- Flow-Through vs. C Corporation (2 of 2)Through vs. C Corporation (2 of 2)C corporation modelATA = contrib x [(1 + rc)n – (1-tp) + tp] Rc – Before tax rate of returnTp – Owner’s marginal tax rate©2007 Prentice Hall, Inc.18-18Other Applications of Other Applications of Investment ModelsInvestment Models Current Current Salary vs. Deferred Comp (1 of 2)Salary vs. Deferred Comp (1 of 2)Employee’s point of viewCurrent salaryPay taxes currentlyInvest after-tax dollarsDeferred salaryPay tax in year of receiptInvest before-tax dollars©2007 Prentice Hall, Inc.18-19Other Applications of Other Applications of Investment ModelsInvestment Models Current Current Salary vs. Deferred Comp (2 of 2)Salary vs. Deferred Comp (2 of 2)Employer’s point of viewCurrent salaryImmediate tax benefitSalary less tax benefit is employers after-tax salary expenseDeferred salaryHave after-tax salary expense available for investment until time n when deferred compensation is paid©2007 Prentice Hall, Inc.18-20Implicit Taxes and Implicit Taxes and ClientelesClienteles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 durationComments or questions about PowerPoint Slides?Contact Dr. Richard Newmark atUniversity of Northern Colorado’sKenneth W. Monfort College of [email protected]©2007 Prentice Hall,