LOS f: Describe the tax profile of different types of investment accounts and the impact they have on after-tax returns and future accumulations.

Q1. An investor who lives in a country with a flat tax regime is trying to decide whether to open a tax-deferred account or a tax-exempt account for retirement savings. The investor would:

A)   choose a tax exempt account over a tax-deferred account if the investor thought her income would be lower after retirement.

B)   be indifferent between the two accounts as long as the flat tax rate does not increase.

C)   choose a tax exempt account over a tax-deferred account if the investor thought her income would be higher after retirement.

Q2. 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)   Neither would benefit because tax-deferred accounts do little to enhance the returns of diversified portfolios.

C)   Conner would benefit more than Pope.

Q3. In a tax-exempt account, contributions to the account are made with:

A)   after-tax funds and reduce the investor’s current tax bill.

B)   after-tax funds and do not reduce the investor’s current tax bill.

C)   pre-tax funds and reduce the investor’s current tax bill.

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Q1. An investor who lives in a country with a flat tax regime is trying to decide whether to open a tax-deferred account or a tax-exempt account for retirement savings. The investor would:

A)   choose a tax exempt account over a tax-deferred account if the investor thought her income would be lower after retirement.

B)   be indifferent between the two accounts as long as the flat tax rate does not increase.

C)   choose a tax exempt account over a tax-deferred account if the investor thought her income would be higher after retirement.

Correct answer is B)

If the tax rate does not change either from a change in the investor’s income or a change in the tax law, the future value will be the same.

Q2. 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)   Neither would benefit because tax-deferred accounts do little to enhance the returns of diversified portfolios.

C)   Conner would benefit more than Pope.

Correct answer is C)

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.

Q3. In a tax-exempt account, contributions to the account are made with:

A)   after-tax funds and reduce the investor’s current tax bill.

B)   after-tax funds and do not reduce the investor’s current tax bill.

C)   pre-tax funds and reduce the investor’s current tax bill.

Correct answer is B)

The tax benefit for a tax-exempt account occurs when the funds are withdrawn.