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Assume that €125,000 is invested in a tax-exempt account. What is the after-tax balance in the account after 15 years if the tax rate is 28% and the pre-tax return is 11%?
A)
€465,613.
B)
€598,074.
C)
€392,138.



The balance in the account in 15 years uses the future value interest factor for a tax-exempt account (FVIFTEA). No taxes are due on the future accumulation.
FVIFTEA = (1 + R)N
FV = 125,000[FVIFTEA]
FV = 125,000[(1.11)15]
FV = 598,074
The response of €392,138 is the future accumulation for an account taxed annually. The response of €465,613 is the future accumulation for an account with tax deferred capital gains and a basis of €125,000.

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You compute that an investment with a current value and basis equal to $20,000 will have an annual return after realized taxes equal to 10% for the next 12 years until it is sold. The effective capital gains rate will be 15%. What will be the accrual equivalent after-tax return?
A)
8.50%.
B)
12.50%.
C)
9.02%.



The balance in the account after payment of all taxes in 12 years uses the future value interest factor after all taxes:Future value = $20,000 × [((1.1)12) × (1 − 0.15) + 0.15] = $56,353
The accrual equivalent after-tax return is then ($56,353 / $20,000)1/12 − 1 = 9.02%.

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An investor deposited $33,000 in a zero coupon bond position 20 years ago. It consisted of 100 zero coupon bonds each with a face value of $1,000 and 20 years to maturity. The investor’s current marginal tax rate is 30%. At maturity, and after all taxes have been paid, the value of the position is $84,500. Compute the accrual equivalent after-tax return.
A)
4.33%.
B)
3.99%.
C)
4.81%.



The accrual equivalent after-tax return = 4.81% = ($84,500 / $33,000)(1/20) − 1. The current marginal tax rate is not relevant to solving the problem.

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An investor deposited $54,000 in a zero coupon bond position 10 years ago. It consisted of 100 zero coupon bonds each with a face value of $1,000 and 10 years to maturity. The investor’s average marginal tax rate is currently 20%. At maturity after all taxes have been paid, the value of the position is $92,000. Compute the accrual equivalent tax rate.
A)
12.18%.
B)
16.27%.
C)
14.00%.



The accrual equivalent after-tax return = 5.47% = ($92,000 / $54,000)(1/10) − 1
The pre-tax return would have been 6.36% = ($100,000 / $54,000)(1/10) − 1
The accrual equivalent tax rate is then 14% = 1 − (5.47% / 6.36%)

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Given an accrual equivalent after-tax return equal 6% and a pre-tax return equal to 7.2%, what is the accrual equivalent tax rate?
A)
16.67%.
B)
12.93%.
C)
20.00%.



The accrual equivalent after-tax rate is:
0.1667 = 16.67% = 1 − (6% / 7.2%).

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An investor faces the periodic payment of investment income taxes. With respect to the relationship between investment horizon and investment return, the tax drag is:
A)
negatively related to both the horizon and investment return.
B)
positively related to both the horizon and investment return.
C)
positively related to the horizon and negatively related to the investment return.



Both a longer horizon and a higher return will increase the tax drag.

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If the tax rate is positive and there is periodic payment of investment income taxes, then which of the following relationships is most accurate?
A)
Tax drag = tax rate.
B)
Tax drag < tax rate.
C)
Tax drag > tax rate.



Under the given conditions: tax drag > tax rate. This is because the tax rate is being applied periodically to a value (the taxable gain or investment income) that is increasing at a compound rate.

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The tax drag from both longer investment horizons and higher investment returns:
A)
are unrelated, and each has a linear relationship with cash drag that is independent of the other.
B)
have a multiplicative effect, so that the tax drag increases rapidly as the investment horizon and the returns increase.
C)
have an offsetting effect, so the tax drag can be zero in some cases where the investment horizon and returns are greater than zero.



They are multiplicative in the formula. Thus, when both are increased, the tax drag rapidly increases.

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An individual, aged 40, is currently in the 25% marginal tax bracket, and expects to be in the 15% bracket when he retires. Making contributions today to a tax-deductible individual retirement account is an example of:
A)
deferring the timing of the tax payment.
B)
both minimizing the amount and deferring the timing of the tax payment.
C)
minimizing the amount of the tax payment.



The investor’s action is an example of both minimizing and deferring. He will minimize taxes by converting income that would have been taxed at a 25% rate today to a lower 15% rate in the future. He will defer taxes payable until the funds are withdrawn from the account in the future.

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Sam Conner and Bill Pope live in different countries. In Conner’s country, there is a light capital gain tax regime. In Pope’s country there is a heavy capital gain tax regime. They both are building diversified portfolios that hold non-dividend-paying growth stocks, dividend-paying stocks, and coupon-paying bonds. They both have a buy-and-hold strategy. Which, if either, would probably benefit the most from a tax-deferred account (TDA)?
A)
Pope would benefit more than Conner.
B)
Conner would benefit more than Pope.
C)
Neither would benefit because tax-deferred accounts do little to enhance the returns of diversified portfolios.



Conner would benefit more. In a light capital gain tax regime, dividends and interest do not receive favorable tax-treatment. There would be an advantage to having them in the TDA. In the heavy capital gain tax regime, interest and dividends receive tax advantages.

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