8: INCOME TAX PLANNING wski has a diversified portfolio of securities with a mar
ID: 1175300 • Letter: 8
Question
8: INCOME TAX PLANNING wski has a diversified portfolio of securities with a market (adjusted cost base) of $50,000. He expects an average compound growth rate of the value of the portfolio to be 8% pa. Every purchase or sale costs .2% of the market value. His marginal tax rate is 40% now and in the future. He could sell the portfolio now, pay tax, and reinvest the remainder, or he could hold it without selling until he retires in Lawrence Kryzano value of $70,000 and an ACB 14 years. In either case he will sell everything at the end of 14 years. (a) How much more money will he have in 14 years, after tax, if he chooses to hold everything until then instead of selling now and reinvesting? (b) In practice, he probably wouldn't sell everything when he retires. Why not? What part of the question is invalid if he sells everything in one year? How can he avoid the problem?Explanation / Answer
A.
If the entire portfolio is sold today
Amount received = 70000
Commission = 70000*.2% =140
Tax = (70000-50000-140)*40% = 7944
Amount reinvested = (70000-140-7944)*(1-0.2%) = 61792
Amount received after 14 years = 61792 * ((1.08)^14)* (1-0.2%) = 181133.
If the portfolio is sold after 14 years
Portfolio value = 70000 * (1.08^14) = 205603.55
Commission = 205603.55*.2% =411
Adjusted Cost = 50000 * (1.08^14) = 146860
Amount received = 205603.55-411-((205603.55-411-146860)*0.40) = 181859
Since the reinvesting rate is the same, the only reason for the difference is the buying and selling commission. In case there were no commission, the value from both the methods would have been same.
B.
The question specifies marginal tax rate of flat 40% and not slab rates based on the income earned. In case slab rates were there, selling the entire portfolio in more than 1 year would be best as it will attract lesser tax compred to selling the entire portfolio in a year.
Thus, Lawrence will not sell the entire protfolio due to higher tax liability.
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