Foi12 Ch17 Answers
Content
Answers to Concepts in Review
1. Tax planning refers to strategies used to reduce or defer the amount of a person’s tax liability. The federal income tax structures for 2012 and 2013 are shown below: 2012: Income Level Individual Returns (in $) 0–8,700 8,701–35,350 35,351–85,650 85,651–178,650 178,651–388,350 Over 388,350 Joint Returns (in $) 0–17,400 17,401–70,700 70,701–142,700 142,701–217,450 217,451–388,350 Over 388,350 Tax Rates 10% 15% 25% 28% 33% 35%
2013 (unofficial): Income Level Individual Returns (in $) 0–8,925 8,926–36,250 36,251–87,850 87,851–183,350 183,351–398,350 398,350–400,000 Over 400,000 Joint Returns (in $) 0–17,850 17,851–72,500 72,501–146,400 146,401–223,050 223,051–398,350 398,351–450,000 Over 450,000 Tax Rates 10% 15% 25% 28% 33% 35% 39.6%
Because you pay a higher percentage on income over certain limits, the tax structure is progressive. The 2013 rates are, of course, more steeply progressive than the 2003–2012 rates. It is important to remember that these are marginal rates, so the 39.6% rate, for example, applies only to income beyond the $400,000 or $450,000 level and even couples with the highest incomes pay only 10% on the first $17,850. 2. A capital asset is anything you own or use for personal purposes, pleasure, or investment. A capital gain (or loss) derived from the sale of a capital asset is calculated as the difference between its sale price and its basis, which is generally equal to its initial purchase price. A gain occurs when the sale price is greater than the basis; a loss is the inverse. Capital gains are taxed as ordinary income, while a maximum of $3,000 of capital losses in excess of capital gains can be applied in any one year. 3. To calculate taxable income: a. Add up all income, then exclude any from sources not subject to income tax (such as interest on municipal bonds). b. Subtract certain allowable deductions, such as IRA contributions and half of the self-employment tax, to get adjusted gross income (AGI). c. Calculate deductions, either by itemizing qualifying deductible items—residential mortgage interest, charitable contributions, some medical and business expenses—or by using the standard deduction.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
d. Multiply number of exemptions times the allowance for the year. e. Subtract deductions and exemptions to get taxable income. Multiplying the taxable income by the tax rate (or using the tax rate schedules) results in the tax liability. This can be further reduced by any tax credits, which reduce the taxes owed dollar for dollar. Tax deductions, however, reduce taxable income and therefore only reduce taxes by the marginal tax rate. The 2013 tax structure phases out itemized deductions and personal exemptions at the highest income levels. 4. Tax avoidance is concerned with reducing or eliminating taxes in legal ways that comply with the intent of Congress. Tax deferral is a strategy for delaying taxes by shifting income subject to tax into a later period when it may receive more favorable tax treatment as a result of a lower tax rate. Both of these tax minimization strategies are completely legal and acceptable. They are not forms of tax evasion, which is an illegal activity designed to avoid paying taxes by omitting income or overstating deductions. These tax minimization strategies are types of tax shelters because they offer potential reductions in taxable income. Clearly, a number of specific tax avoidance and tax deferral techniques exist. 5. A tax shelter is an investment vehicle that offers potential reductions of taxable income. Sole proprietorships, partnerships, and other similar forms of business can pass on losses resulting from certain deductions—depreciation, depletion, and amortization—directly to individual owners; the amounts are limited by law. In contrast, the owners of a corporation—the shareholders—receive no immediate benefit from tax losses. An exception is when the corresponding market price of the shares falls: The investor can deduct up to $3,000 of capital losses per year (in excess of capital gains) from income. 6. Tax-favored income refers to investment returns that are not taxable, that are taxed at a rate less than that on other similar investments, that defer the payment of taxes to a later period, or that trade current income for capital gains. a. Interest earned on tax-free municipal bonds is free of federal income taxes and may also be free of state income taxes for residents of the issuing state. These bonds are, however, subject to tax regulations covering capital gains and losses. b. Interest on Treasury and government agency securities are excluded only from state and local income taxes, not federal income taxes. c. When you sell a personal residence, any capital gain is deferred if another residence is bought within two years. Individuals can exclude $125,000 of the accumulated capital gains from the sale of their personal residence from gross income and couples filing jointly up to $500,000 as long as the property has been held for at least two years. The amount by which the proceeds from the sale of a personal residence exceed its basis (the price originally paid for it) is subject to capital gains taxes. On individual returns, a taxpayer who has owned and used a property as a principal residence for at least two years can exclude up to $250,000 of the gain from its sale. On a joint return, the exclusion applies to as much as $500,000. 7. a. A put hedge locks in profits but doesn’t exclude potential additional price appreciation, as does a short sale against the box. Purchasing a put option on shares the investor owns locks in a price. However, if the share price rises, the investor does not have to exercise the option. This is a good strategy when the price of a security is expected to fluctuate widely above and below the current price.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
b. Selling a deep-in-the-money call option locks in the share price but only to the extent of the amount received from the sale of the call option. The investor gives up any potential price appreciation. Selling this type of call option is a good technique when an investor expects the price of the shares to vary only a small amount from the current price. If an investor expects the future price of the securities to be above the current price, the best strategy is to continue to hold the stock and do nothing. 8. a. 401(k) plans are supplemental retirement plans that allow employees to divert a portion of their salaries to a company-sponsored, tax-sheltered savings account, thus deferring taxes until retirement. Some employers provide a matching contribution, up to a specified amount; other plans only include voluntary contributions. Unlike an IRA, 401(k) plans are more flexible in allowing withdrawals prior to retirement age in the case of a clearly defined financial hardship, such as high medical expenses or college bills. Therefore, the benefits of 401(k) plans include tax deferral, possible employer compensation, and flexibility if needed. b. Keogh plans are retirement plans that permit self-employed people to contribute up to 20% of their earned income, up to a $40,000 maximum, to a retirement plan on a pretax basis. The main advantages of these plans are the fairly high maximum deduction and its ease of administration. Its main disadvantage is the complicated tax-reporting requirements. Small business owners can open Keogh-like plans that are easier to administer, such as the Simplified Employee Pension Plan (SEP-IRA) and Savings Incentive Match Plan for Employees (SIMPLE) IRA. c. Individual retirement plans (IRAs) are investment accounts established by individuals that can be used for any type of investment. They are limited to annual contributions of $5,000 for an individuals under the age of 50 and $6,000 for those over 50 until the age when compulsory withdrawals must begin (70 ½). Under certain conditions, both IRA contributions and earnings are tax-deferred until withdrawal. Persons who are covered by company-sponsored pension plans are not eligible to deduct their IRA contributions for tax purposes. Advantages of the IRA include its simplicity and flexibility. Disadvantages include the potentially confusing array of fully, partially, and nondeductible situations. 9. a. Traditional deductible IRA. These IRAs are self-directed, tax-deferred retirement programs that are available to any gainfully employed individual. The amount of IRA contributions can be shown on the tax return as a deduction from taxable income, which reduces the amount of taxes that have to be paid. b. Roth IRA. The contributions to a Roth IRA are nondeductible—you will have already paid taxes on the money you put into it. But as long as you are age 59 or older and the account is at least five years old, withdrawals are tax-free. Otherwise, the earnings are taxed, and you may be subject to a 10% penalty. Clearly, the tax-free accumulation in a Roth IRA makes it an attractive vehicle for tax deferral. c. Nondeductible IRA. A nondeductible IRA allows taxpayers who fail to meet the income cutoffs for the traditional deductible IRA or Roth IRA to obtain the benefit of tax-deferred earnings. Like a traditional IRA, the earnings in this IRA accumulate tax-free until you withdraw funds. d. SIMPLE IRA. A retirement savings plan for small business owners that does not include the costs of adopting and managing a regular 401(k) plan. Contributions to a SIMPLE IRA grow taxdeferred until withdrawn in retirement. This plan is ideal for an individual with a part-time second business because contribution limits are 100% of income up to $10,000.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
10. The following help Americans invest after-tax dollars on a tax-deferred basis. a. Coverdell Education Savings Accounts are used to save for the future educational expenses of a child under age 18. Contributions to these accounts are nondeductible. However, earnings accumulate on a tax-free basis and withdrawals may be tax-exempt if used for education expenses. b. Section 529 College Savings Plans are state-sponsored, tax-deferred college savings plans with annual contributions that can equal $11,000 per year and up to $270,000 per student (depending on the plan). 11. A guaranteed investment contract (GIC) is a popular investment for 401(k) plan investment. Sold by insurance companies to pension plan managers, the GIC is a portfolio of fixed-income securities with a guaranteed competitive rate of return. Employees can choose to place part or all of their 401(k) money in GICs; the guaranteed return makes them a popular choice, and they account for about 60% of all 401(k) investments. Recently, the crisis in the insurance industry has prompted many investors to reconsider their GICs and to carefully investigate the insurance company offering the GIC for their 401(k) plan. A number of funding vehicles, such as long-term securities, common stock, mutual funds, and money market accounts or other short-term securities, can be used to fund Keoghs and IRAs. Investments that have good tax-sheltering qualities, such as municipal bonds, should not be used for these types of retirement accounts. Also, low-risk investments are best suited for building secure retirement funds. 12. a. Growth stocks are shares in a company that is rapidly growing and in need of capital for expansion. Such a company generally defers dividends to common stockholders and reinvests the funds to finance its growth. As a result, the investor’s equity interest in the firm increases. The dividends, if issued at present, would be taxed as ordinary income. If reinvested, the tax would be deferred, and only future dividends or capital gains (when the securities are sold at a price greater than the initial purchase price) would be taxed. b. Deep discount bonds can be purchased at a price far below their par value. Purchasers of these bonds realize relatively low levels of periodic interest income and generally sizable capital gains when the bond is sold at a price greater than the purchase price or redeemed at maturity. In the latter case, the gain would be the difference between the par value and the purchase price. These bonds therefore provide most of the return when sold or at maturity rather than through periodic interest payments, thereby trading current income for capital gains income. c. With income property depreciation, the property is depreciated according to one of a number of systems specified by law. Depreciation reduces an investor’s tax liability because it is a noncash tax write-off. When a property is sold at a price equal to the original purchase price, the capital gain equals the amount of depreciation taken. Thus, ordinary income is converted into capital gains. While the Tax Reform Act of 1986 has somewhat limited the use of depreciation tax benefits, the primary benefit provided by depreciation is tax deferral through the exchange of current income for future capital gains. 13. A tax swap is nothing more than the replacement of one security with another in order to partially or fully offset a capital gain that has been realized in another part of the portfolio. For example, suppose that during the past year an investor realized a capital gain of $1,500 on the sale of Stock A. Also, suppose that this investor is holding 100 shares of Stock B, which has suffered a $14 per share loss. The individual wants to maintain a position in the given industry but doesn’t care if the holding is in Stock B or some other similar computer firm. The investor needs the stock to maintain the present level of diversification and/or risk in his or her portfolio. Therefore, the investor sells Stock B and takes a $1,400 loss on the sale. This loss is then used to offset all but $150 of the capital gain realized
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
on Stock A. Only $150 will then be taxable. To maintain his or her position in the industry, the investor purchases 100 shares of Stock C (a similar company in the same industry as Stock B), which is presently selling at the same price as Stock B. The investor maintains the desired mix in his or her portfolio as a result of swapping these securities and, in the process, considerably reduces taxes. 14. An annuity is a series of payments guaranteed for a number of years or over a lifetime. All funds earned and held in the annuity are nontaxable until paid out to the annuitant. Taxes must be paid when funds are distributed; this is usually when the annuitant is in a lower tax bracket. Therefore, the taxes paid on the distribution of funds would be reduced. An investor can use an annuity to defer taxes and generate greater earnings from reinvestment of pretax rather than after-tax dollars. Annuities are frequently used in retirement plans. a. A single-premium annuity is one in which the purchaser pays a single lump sum for the contract and receives a series of payments that begin immediately or at some future date. An installment annuity is one that is acquired by making payments over time. At a specified future date, the installment payments, plus interest earned on them, are used to purchase an annuity contract. b. An immediate annuity is a contract under which payments to the annuitant begin as soon as it is purchased. A deferred annuity is one in which the payments to the annuitant begin at some future date. c. A fixed annuity is written so that once a payment schedule is selected, the amount of the monthly payment does not change. A variable annuity is one in which the monthly payment adjusts according to the investment experience (and sometimes mortality experience) of the insurer. 15. a. An annuity contract’s current interest rate is the yearly return the insurance company is currently paying on accumulated deposits. b. The minimum guaranteed interest rate is the minimum interest rate on contributions that the insurance company will guarantee over the full accumulation period, usually substantially less than the current interest rate. c. The payout is the investment return provided by an annuity contract, realized when the distribution period begins. A straight annuity offers a series of payments for the rest of the annuitant’s life. Other payout options include payments for both the annuitant and spouse for the rest of both their lives, as well as a contract specifying rapid payout of accumulated payments with interest over a short period of time. 16. Anyone can purchase a deferred annuity contract. The funds used for the purchase immediately begin to accrue interest. In a regular bank savings account, this interest is credited as it is earned and, consequently, is taxed at the prevailing ordinary tax rate. The tax payment reduces the return significantly. Accrued interest on a deferred annuity is not taxed until it is paid out to the annuitant. The payout is usually begun when the annuitant’s tax rate is less than the current rate, and therefore, the after-tax return is greater than on comparable savings instruments where tax is levied at the investor’s current rate. Also, because the annuity interest is retained in the fund and becomes part of the principal, the accrued earnings become progressively greater through compounding. With a deferred annuity, the investor protects his or her funds from present taxes and benefits from compound interest earnings on pre-tax dollars. The tax-sheltered annuity is an annuity contract available to certain employees of institutions such as schools, governments, and not-for-profit organizations that allows them to make tax-free contributions from current income to purchase a deferred annuity. The tax-sheltered annuity is attractive because it can save incomes taxes today as well as provide a higher level of retirement income later.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
The selection of a deferred annuity over an IRA as a tax shelter may depend on the time frame for the payout of funds, the future use and need of the funds, and the amount of funds required. If one plans to use the funds as part of a retirement plan, the maximum amount allowed should be put into an IRA. This is because not only is the tax liability deferred on interest income, but also an annual IRA deposit of up to $5,000 per working person can be deducted from taxable income. The purchase price of the annuity is tax deductible only when the annuitant is in one of the professional fields qualified to purchase a tax-sheltered annuity. Unfortunately, as a result of the Tax Reform Act of 1986, IRA contributions may not be tax deductible. So whether an IRA or a deferred annuity is a better tax shelter depends upon whether the taxpayer qualifies for a tax-deductible IRA or a tax-sheltered annuity. 17. The principal positive feature of deferred annuities is that they allow the investor to accumulate tax-deferred earnings. Interest accumulates more quickly than if earnings were taxed. Also, deferred annuities are low-risk investments. Some negative aspects of deferred annuities are the lack inflation protection and the high sales charges and administration fees. Thus, deferred annuities are not an inflation hedge and the returns tend to be reduced because of costs. Before buying an annuity, an investor should analyze the prospectus and compare it against any other available literature. If the annuity fits with the investor’s objectives, if performance has been good, and the bond ratings meet the investor’s criteria, he or she can purchase the annuity through a stockbroker or licensed salesperson. 18. In a general partnership, all partners have management rights, and all assume unlimited liability for partnership debts or obligations. A corporation has an indefinite life, and its shareholder investors have limited liability. Any tax losses generated by a corporation cannot be passed on to its shareholders, whereas a partnership passes through profits and losses to the partners, who are subject to the resulting tax consequences. The limited partnership (LP) provides the limited liability of the corporation but allows the pass-through of profits and losses in a fashion similar to the general partnership. The limited partnership (LP) is a syndicate involving one or more general partners who are responsible for the management of the partnership’s activities and are liable for all of its debts and obligations, and the limited partners who strictly provide financing are not active in management (i.e., passive owners), have limited liability, and can use allowable tax advantages of any losses and/or depreciation, etc. of the partnership’s activities. This partnership must conform with certain legal requirements and IRS regulations. The Tax Reform Act of 1986 effectively eliminated the tax-sheltering appeal of LPs. The act limits the tax deductibility of net losses generated by passive activities to the amount of net income earned by the taxpayer on all passive activities. This severely restricts the attractiveness of most LPs with two exceptions: certain oil and gas property agreements and a limited amount of losses on rental properties for actively participating taxpayers. 19. The limited liability company (LLC) combines the corporate advantage of limited liability with the partnership-like tax regulations. LLC businesses are owned by members, who can manage the firm themselves or employ a group of managers. The Tax Reform Act of 1986 limited the tax deductions for net losses generated by passive activities to the amount of net income earned by the taxpayer on all activities. LLCs should, therefore, be viewed on the basis of their investment merits.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
Answers to Concepts in Review
1. Tax planning refers to strategies used to reduce or defer the amount of a person’s tax liability. The federal income tax structures for 2012 and 2013 are shown below: 2012: Income Level Individual Returns (in $) 0–8,700 8,701–35,350 35,351–85,650 85,651–178,650 178,651–388,350 Over 388,350 Joint Returns (in $) 0–17,400 17,401–70,700 70,701–142,700 142,701–217,450 217,451–388,350 Over 388,350 Tax Rates 10% 15% 25% 28% 33% 35%
2013 (unofficial): Income Level Individual Returns (in $) 0–8,925 8,926–36,250 36,251–87,850 87,851–183,350 183,351–398,350 398,350–400,000 Over 400,000 Joint Returns (in $) 0–17,850 17,851–72,500 72,501–146,400 146,401–223,050 223,051–398,350 398,351–450,000 Over 450,000 Tax Rates 10% 15% 25% 28% 33% 35% 39.6%
Because you pay a higher percentage on income over certain limits, the tax structure is progressive. The 2013 rates are, of course, more steeply progressive than the 2003–2012 rates. It is important to remember that these are marginal rates, so the 39.6% rate, for example, applies only to income beyond the $400,000 or $450,000 level and even couples with the highest incomes pay only 10% on the first $17,850. 2. A capital asset is anything you own or use for personal purposes, pleasure, or investment. A capital gain (or loss) derived from the sale of a capital asset is calculated as the difference between its sale price and its basis, which is generally equal to its initial purchase price. A gain occurs when the sale price is greater than the basis; a loss is the inverse. Capital gains are taxed as ordinary income, while a maximum of $3,000 of capital losses in excess of capital gains can be applied in any one year. 3. To calculate taxable income: a. Add up all income, then exclude any from sources not subject to income tax (such as interest on municipal bonds). b. Subtract certain allowable deductions, such as IRA contributions and half of the self-employment tax, to get adjusted gross income (AGI). c. Calculate deductions, either by itemizing qualifying deductible items—residential mortgage interest, charitable contributions, some medical and business expenses—or by using the standard deduction.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
d. Multiply number of exemptions times the allowance for the year. e. Subtract deductions and exemptions to get taxable income. Multiplying the taxable income by the tax rate (or using the tax rate schedules) results in the tax liability. This can be further reduced by any tax credits, which reduce the taxes owed dollar for dollar. Tax deductions, however, reduce taxable income and therefore only reduce taxes by the marginal tax rate. The 2013 tax structure phases out itemized deductions and personal exemptions at the highest income levels. 4. Tax avoidance is concerned with reducing or eliminating taxes in legal ways that comply with the intent of Congress. Tax deferral is a strategy for delaying taxes by shifting income subject to tax into a later period when it may receive more favorable tax treatment as a result of a lower tax rate. Both of these tax minimization strategies are completely legal and acceptable. They are not forms of tax evasion, which is an illegal activity designed to avoid paying taxes by omitting income or overstating deductions. These tax minimization strategies are types of tax shelters because they offer potential reductions in taxable income. Clearly, a number of specific tax avoidance and tax deferral techniques exist. 5. A tax shelter is an investment vehicle that offers potential reductions of taxable income. Sole proprietorships, partnerships, and other similar forms of business can pass on losses resulting from certain deductions—depreciation, depletion, and amortization—directly to individual owners; the amounts are limited by law. In contrast, the owners of a corporation—the shareholders—receive no immediate benefit from tax losses. An exception is when the corresponding market price of the shares falls: The investor can deduct up to $3,000 of capital losses per year (in excess of capital gains) from income. 6. Tax-favored income refers to investment returns that are not taxable, that are taxed at a rate less than that on other similar investments, that defer the payment of taxes to a later period, or that trade current income for capital gains. a. Interest earned on tax-free municipal bonds is free of federal income taxes and may also be free of state income taxes for residents of the issuing state. These bonds are, however, subject to tax regulations covering capital gains and losses. b. Interest on Treasury and government agency securities are excluded only from state and local income taxes, not federal income taxes. c. When you sell a personal residence, any capital gain is deferred if another residence is bought within two years. Individuals can exclude $125,000 of the accumulated capital gains from the sale of their personal residence from gross income and couples filing jointly up to $500,000 as long as the property has been held for at least two years. The amount by which the proceeds from the sale of a personal residence exceed its basis (the price originally paid for it) is subject to capital gains taxes. On individual returns, a taxpayer who has owned and used a property as a principal residence for at least two years can exclude up to $250,000 of the gain from its sale. On a joint return, the exclusion applies to as much as $500,000. 7. a. A put hedge locks in profits but doesn’t exclude potential additional price appreciation, as does a short sale against the box. Purchasing a put option on shares the investor owns locks in a price. However, if the share price rises, the investor does not have to exercise the option. This is a good strategy when the price of a security is expected to fluctuate widely above and below the current price.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
b. Selling a deep-in-the-money call option locks in the share price but only to the extent of the amount received from the sale of the call option. The investor gives up any potential price appreciation. Selling this type of call option is a good technique when an investor expects the price of the shares to vary only a small amount from the current price. If an investor expects the future price of the securities to be above the current price, the best strategy is to continue to hold the stock and do nothing. 8. a. 401(k) plans are supplemental retirement plans that allow employees to divert a portion of their salaries to a company-sponsored, tax-sheltered savings account, thus deferring taxes until retirement. Some employers provide a matching contribution, up to a specified amount; other plans only include voluntary contributions. Unlike an IRA, 401(k) plans are more flexible in allowing withdrawals prior to retirement age in the case of a clearly defined financial hardship, such as high medical expenses or college bills. Therefore, the benefits of 401(k) plans include tax deferral, possible employer compensation, and flexibility if needed. b. Keogh plans are retirement plans that permit self-employed people to contribute up to 20% of their earned income, up to a $40,000 maximum, to a retirement plan on a pretax basis. The main advantages of these plans are the fairly high maximum deduction and its ease of administration. Its main disadvantage is the complicated tax-reporting requirements. Small business owners can open Keogh-like plans that are easier to administer, such as the Simplified Employee Pension Plan (SEP-IRA) and Savings Incentive Match Plan for Employees (SIMPLE) IRA. c. Individual retirement plans (IRAs) are investment accounts established by individuals that can be used for any type of investment. They are limited to annual contributions of $5,000 for an individuals under the age of 50 and $6,000 for those over 50 until the age when compulsory withdrawals must begin (70 ½). Under certain conditions, both IRA contributions and earnings are tax-deferred until withdrawal. Persons who are covered by company-sponsored pension plans are not eligible to deduct their IRA contributions for tax purposes. Advantages of the IRA include its simplicity and flexibility. Disadvantages include the potentially confusing array of fully, partially, and nondeductible situations. 9. a. Traditional deductible IRA. These IRAs are self-directed, tax-deferred retirement programs that are available to any gainfully employed individual. The amount of IRA contributions can be shown on the tax return as a deduction from taxable income, which reduces the amount of taxes that have to be paid. b. Roth IRA. The contributions to a Roth IRA are nondeductible—you will have already paid taxes on the money you put into it. But as long as you are age 59 or older and the account is at least five years old, withdrawals are tax-free. Otherwise, the earnings are taxed, and you may be subject to a 10% penalty. Clearly, the tax-free accumulation in a Roth IRA makes it an attractive vehicle for tax deferral. c. Nondeductible IRA. A nondeductible IRA allows taxpayers who fail to meet the income cutoffs for the traditional deductible IRA or Roth IRA to obtain the benefit of tax-deferred earnings. Like a traditional IRA, the earnings in this IRA accumulate tax-free until you withdraw funds. d. SIMPLE IRA. A retirement savings plan for small business owners that does not include the costs of adopting and managing a regular 401(k) plan. Contributions to a SIMPLE IRA grow taxdeferred until withdrawn in retirement. This plan is ideal for an individual with a part-time second business because contribution limits are 100% of income up to $10,000.
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
10. The following help Americans invest after-tax dollars on a tax-deferred basis. a. Coverdell Education Savings Accounts are used to save for the future educational expenses of a child under age 18. Contributions to these accounts are nondeductible. However, earnings accumulate on a tax-free basis and withdrawals may be tax-exempt if used for education expenses. b. Section 529 College Savings Plans are state-sponsored, tax-deferred college savings plans with annual contributions that can equal $11,000 per year and up to $270,000 per student (depending on the plan). 11. A guaranteed investment contract (GIC) is a popular investment for 401(k) plan investment. Sold by insurance companies to pension plan managers, the GIC is a portfolio of fixed-income securities with a guaranteed competitive rate of return. Employees can choose to place part or all of their 401(k) money in GICs; the guaranteed return makes them a popular choice, and they account for about 60% of all 401(k) investments. Recently, the crisis in the insurance industry has prompted many investors to reconsider their GICs and to carefully investigate the insurance company offering the GIC for their 401(k) plan. A number of funding vehicles, such as long-term securities, common stock, mutual funds, and money market accounts or other short-term securities, can be used to fund Keoghs and IRAs. Investments that have good tax-sheltering qualities, such as municipal bonds, should not be used for these types of retirement accounts. Also, low-risk investments are best suited for building secure retirement funds. 12. a. Growth stocks are shares in a company that is rapidly growing and in need of capital for expansion. Such a company generally defers dividends to common stockholders and reinvests the funds to finance its growth. As a result, the investor’s equity interest in the firm increases. The dividends, if issued at present, would be taxed as ordinary income. If reinvested, the tax would be deferred, and only future dividends or capital gains (when the securities are sold at a price greater than the initial purchase price) would be taxed. b. Deep discount bonds can be purchased at a price far below their par value. Purchasers of these bonds realize relatively low levels of periodic interest income and generally sizable capital gains when the bond is sold at a price greater than the purchase price or redeemed at maturity. In the latter case, the gain would be the difference between the par value and the purchase price. These bonds therefore provide most of the return when sold or at maturity rather than through periodic interest payments, thereby trading current income for capital gains income. c. With income property depreciation, the property is depreciated according to one of a number of systems specified by law. Depreciation reduces an investor’s tax liability because it is a noncash tax write-off. When a property is sold at a price equal to the original purchase price, the capital gain equals the amount of depreciation taken. Thus, ordinary income is converted into capital gains. While the Tax Reform Act of 1986 has somewhat limited the use of depreciation tax benefits, the primary benefit provided by depreciation is tax deferral through the exchange of current income for future capital gains. 13. A tax swap is nothing more than the replacement of one security with another in order to partially or fully offset a capital gain that has been realized in another part of the portfolio. For example, suppose that during the past year an investor realized a capital gain of $1,500 on the sale of Stock A. Also, suppose that this investor is holding 100 shares of Stock B, which has suffered a $14 per share loss. The individual wants to maintain a position in the given industry but doesn’t care if the holding is in Stock B or some other similar computer firm. The investor needs the stock to maintain the present level of diversification and/or risk in his or her portfolio. Therefore, the investor sells Stock B and takes a $1,400 loss on the sale. This loss is then used to offset all but $150 of the capital gain realized
Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 17
on Stock A. Only $150 will then be taxable. To maintain his or her position in the industry, the investor purchases 100 shares of Stock C (a similar company in the same industry as Stock B), which is presently selling at the same price as Stock B. The investor maintains the desired mix in his or her portfolio as a result of swapping these securities and, in the process, considerably reduces taxes. 14. An annuity is a series of payments guaranteed for a number of years or over a lifetime. All funds earned and held in the annuity are nontaxable until paid out to the annuitant. Taxes must be paid when funds are distributed; this is usually when the annuitant is in a lower tax bracket. Therefore, the taxes paid on the distribution of funds would be reduced. An investor can use an annuity to defer taxes and generate greater earnings from reinvestment of pretax rather than after-tax dollars. Annuities are frequently used in retirement plans. a. A single-premium annuity is one in which the purchaser pays a single lump sum for the contract and receives a series of payments that begin immediately or at some future date. An installment annuity is one that is acquired by making payments over time. At a specified future date, the installment payments, plus interest earned on them, are used to purchase an annuity contract. b. An immediate annuity is a contract under which payments to the annuitant begin as soon as it is purchased. A deferred annuity is one in which the payments to the annuitant begin at some future date. c. A fixed annuity is written so that once a payment schedule is selected, the amount of the monthly payment does not change. A variable annuity is one in which the monthly payment adjusts according to the investment experience (and sometimes mortality experience) of the insurer. 15. a. An annuity contract’s current interest rate is the yearly return the insurance company is currently paying on accumulated deposits. b. The minimum guaranteed interest rate is the minimum interest rate on contributions that the insurance company will guarantee over the full accumulation period, usually substantially less than the current interest rate. c. The payout is the investment return provided by an annuity contract, realized when the distribution period begins. A straight annuity offers a series of payments for the rest of the annuitant’s life. Other payout options include payments for both the annuitant and spouse for the rest of both their lives, as well as a contract specifying rapid payout of accumulated payments with interest over a short period of time. 16. Anyone can purchase a deferred annuity contract. The funds used for the purchase immediately begin to accrue interest. In a regular bank savings account, this interest is credited as it is earned and, consequently, is taxed at the prevailing ordinary tax rate. The tax payment reduces the return significantly. Accrued interest on a deferred annuity is not taxed until it is paid out to the annuitant. The payout is usually begun when the annuitant’s tax rate is less than the current rate, and therefore, the after-tax return is greater than on comparable savings instruments where tax is levied at the investor’s current rate. Also, because the annuity interest is retained in the fund and becomes part of the principal, the accrued earnings become progressively greater through compounding. With a deferred annuity, the investor protects his or her funds from present taxes and benefits from compound interest earnings on pre-tax dollars. The tax-sheltered annuity is an annuity contract available to certain employees of institutions such as schools, governments, and not-for-profit organizations that allows them to make tax-free contributions from current income to purchase a deferred annuity. The tax-sheltered annuity is attractive because it can save incomes taxes today as well as provide a higher level of retirement income later.
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The selection of a deferred annuity over an IRA as a tax shelter may depend on the time frame for the payout of funds, the future use and need of the funds, and the amount of funds required. If one plans to use the funds as part of a retirement plan, the maximum amount allowed should be put into an IRA. This is because not only is the tax liability deferred on interest income, but also an annual IRA deposit of up to $5,000 per working person can be deducted from taxable income. The purchase price of the annuity is tax deductible only when the annuitant is in one of the professional fields qualified to purchase a tax-sheltered annuity. Unfortunately, as a result of the Tax Reform Act of 1986, IRA contributions may not be tax deductible. So whether an IRA or a deferred annuity is a better tax shelter depends upon whether the taxpayer qualifies for a tax-deductible IRA or a tax-sheltered annuity. 17. The principal positive feature of deferred annuities is that they allow the investor to accumulate tax-deferred earnings. Interest accumulates more quickly than if earnings were taxed. Also, deferred annuities are low-risk investments. Some negative aspects of deferred annuities are the lack inflation protection and the high sales charges and administration fees. Thus, deferred annuities are not an inflation hedge and the returns tend to be reduced because of costs. Before buying an annuity, an investor should analyze the prospectus and compare it against any other available literature. If the annuity fits with the investor’s objectives, if performance has been good, and the bond ratings meet the investor’s criteria, he or she can purchase the annuity through a stockbroker or licensed salesperson. 18. In a general partnership, all partners have management rights, and all assume unlimited liability for partnership debts or obligations. A corporation has an indefinite life, and its shareholder investors have limited liability. Any tax losses generated by a corporation cannot be passed on to its shareholders, whereas a partnership passes through profits and losses to the partners, who are subject to the resulting tax consequences. The limited partnership (LP) provides the limited liability of the corporation but allows the pass-through of profits and losses in a fashion similar to the general partnership. The limited partnership (LP) is a syndicate involving one or more general partners who are responsible for the management of the partnership’s activities and are liable for all of its debts and obligations, and the limited partners who strictly provide financing are not active in management (i.e., passive owners), have limited liability, and can use allowable tax advantages of any losses and/or depreciation, etc. of the partnership’s activities. This partnership must conform with certain legal requirements and IRS regulations. The Tax Reform Act of 1986 effectively eliminated the tax-sheltering appeal of LPs. The act limits the tax deductibility of net losses generated by passive activities to the amount of net income earned by the taxpayer on all passive activities. This severely restricts the attractiveness of most LPs with two exceptions: certain oil and gas property agreements and a limited amount of losses on rental properties for actively participating taxpayers. 19. The limited liability company (LLC) combines the corporate advantage of limited liability with the partnership-like tax regulations. LLC businesses are owned by members, who can manage the firm themselves or employ a group of managers. The Tax Reform Act of 1986 limited the tax deductions for net losses generated by passive activities to the amount of net income earned by the taxpayer on all activities. LLCs should, therefore, be viewed on the basis of their investment merits.
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