karoliukas

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%)

karoliukas

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%).

karoliukas

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.

karoliukas

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.

karoliukas

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.

karoliukas

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.

karoliukas

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.

karoliukas

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

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

---

The tax benefit for a tax-exempt account occurs when the funds are withdrawn.

karoliukas

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 change.

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

---

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.

karoliukas

If an investment is held in a tax-exempt account, then the investor bears:

A) none of the investment risk.

B) all of the investment risk.

C) some of the investment risk.

---

In a taxable account, losses realized result in a reduction in taxes that serve to offset the magnitude of the loss. Thus, some of the downside risk is transferred to the government. In a tax-exempt account, the variability of returns is not affected by the taxes.