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Chapter 2 Securities Markets and Transactions 15
Web Chapter 17
Tax-Advantaged Investments
Outline
Learning Goals
I. Tax Fundamentals
A. Taxable Income
B. Determining Taxable Income
1. Gross Income
2. Adjustments to Gross Income
3. Itemized Deductions
4. Exemptions
5. Taxable Income
6. Tax Credits
7. Taxes Due or Refundable
8. The Alternative Minimum Tax
Concepts in Review
II. Tax Strategies
A. Tax Avoidance and Tax Deferral
B. Tax Shelters
Concepts in Review
III. Tax-Favored Income
A. Income Excluded from Taxation
1. Tax-Free Municipal Bond Interest
2. Treasury and Government Agency Issues
3. Sale of Personal Residence
B. Strategies That Defer Tax Liabilities
1. Put Hedge
2. Deep-in-the-Money Call Option
3. Summary of the Strategies
C. Programs That Defer Tax Liabilities to Retirement
1. 401(k) Plans
2. Keogh Plans
3. Individual Retirement Arrangements (IRAs)
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16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
a. Roth IRAs
b. Nondeductible IRAs
4. IRA Features
5. Funding Keoghs and IRAs
D. Tax-Deferred Investing in Education Savings Plans
1. Coverdell Education Savings Accounts (ESA)
2. Section 529 College Savings Plans
E. Strategies That Trade Current Income for Capital Gains
1. Growth versus Income Stocks
2. Deep-Discount Bonds
3. Income Property Depreciation
F. Tax Swaps: A Strategy That Reduces or Eliminates a Tax Liability
Concepts in Review
IV. Deferred Annuities
A. Annuities: An Overview
B. Characteristics of Deferred Annuities
1. Special Tax Features
2. Investment Payout
C. Deferred Annuities and Retirement Plans
D. Fixed versus Variable Annuity
E. Annuities as Investment Vehicles
1. Investment Suitability
2. Buying Annuities
Concepts in Review
V. Syndicated Investments: Limited Partnerships and Limited Liability Corporations
A. Investing in Limited Partnership and Limited Liability Companies
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
Case Problems
17.1 Tax Planning for the Wilsons
Key Concepts
1. Ordinary income versus capital gains and losses
2. Taxable income and its determination
3. Tax avoidance and tax deferral
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Chapter 2 Securities Markets and Transactions 17
4. Tax shelter fundamentals
5. Tax-favored income and categories of income excluded from taxation, partially or wholly
6. Strategies that defer tax liabilities to the next year
7. Strategies that defer taxes until retirement
8. Strategies that trade current income for capital gains
9. Tax swaps to reduce or eliminate a tax liability
10. The concept of annuities, their use as an investment vehicle, and their associated tax benefits
11. The structure and function of annuities, particularly deferred annuities, and their role in an investment
portfolio
12. The structure and popular forms of limited partnerships and their potential tax-sheltering abilities
13. Analysis of limited partnerships as investment vehicles
Overview
The sheltering of income from taxation through various investment media is emphasized in this chapter.
1. The fundamentals of taxation and tax shelters are presented. The student should understand the
different types of income, how they are taxed, and the basic procedure used to determine taxable
income. This is necessary to be able to evaluate the tax-sheltering abilities of alternative investment
vehicles. The concepts of tax avoidance, tax deferral, and tax shelters are presented and compared to
tax evasion.
2. Tax-favored income is defined. Categories of this income include interest on tax-free municipal
bonds and Treasury and government agency issues, and certain proceeds from the sale of a
principal residence.
3. Strategies that defer tax liabilities to the next year are described and demonstrated. They include
shorting-against-the-box, put hedges, and deep-in-the-money call options. The instructor should
emphasize the tax-deferring benefits of these strategies.
4. Programs that defer tax liabilities until retirement include 401(k) plans, Keogh plans, and
individual retirement accounts (IRAs). These allow the investor to postpone taxes on invested funds,
income earned, and capital gains until retirement, when the investor may be in a lower tax bracket.
5. The two educational savings plans that offer tax-deferred investing are the Coverdell Education
Savings Account (ESA) and the Section 529 College Savings Plan. Contributions to Coverdell ESA
accounts are nondeductible, but earnings accumulate tax-free and are tax-exempt if withdrawals are
used to pay for college expenses. Section 529 plans are state-sponsored, tax-deferred college savings
plans. Instructors can compare the two and provide local examples.
6. Trading current income for capital gains requires careful analysis and the implementation of
certain strategies. Three strategies—growth stocks, deep discount bonds, and property depreciation—
are discussed next, always with the tax implications highlighted. Another strategy to reduce or
eliminate a tax liability—the tax swap—is also discussed. The professor should emphasize each
strategy’s tax advantages.
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18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
7. The concept of an annuity is presented, and the various types of annuities are discussed. An
important emphasis in this section is the tax benefits of the annuity—the deferred annuity in
particular. The characteristics of a deferred annuity are described and can be demonstrated with
reference to an actual annuity contract.
8. The role of annuities in retirement plans and as investment vehicles is discussed. It is particularly
important to understand and evaluate the tax implications of an annuity and to consider the high sales
charges and administrative fees often associated with annuity plans. Finally, investors need to assure
themselves of the soundness of the company issuing the annuity plan. When making lifetime
investments, investors need to ask which ends first, their lifetime or the issuing company’s.
9. The final section includes a discussion of limited partnerships and limited liability corporations.
This section offers sufficient information for the student to begin to understand the structure and
forms of the limited partnership and its role as an investment vehicle. The professor may want to
analyze and determine the benefits of a given limited partnership. It is especially important to note
that recent changes in tax law limit tax deductions for passive investors, essentially eliminating this
tax shelter unless the investor also has net income from passive activities.
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 2014 are shown below:
2014: Income Level (Due 4/15/2015)
Individual Returns (in $) Joint Returns (in $) Tax Rates
Because you pay a higher tax rate on higher income levels, the tax structure is progressive. It is
important to remember that these are marginal rates, so the 39.6% rate, for example, applies only to
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
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Chapter 2 Securities Markets and Transactions 19
3. To calculate taxable income:
c. Calculate deductions, either by itemizing qualifying deductible items—residential mortgage
Multiplying the taxable income by the tax rate (or using the tax rate schedules) results in the tax
liability. If the taxpayer has realized long-term capital gains or qualifying dividends, this portion of
4. Tax avoidance is concerned with reducing or eliminating taxes in legal ways that comply with the
Both of these tax minimization strategies are completely legal and acceptable. They are not forms
5. A tax shelter is an investment vehicle that offers potential reductions of taxable income. Sole
proprietorships, partnerships, LLC’s and other similar forms of business can pass on losses resulting
6. Tax-favored income refers to investment returns that are not taxable, are taxed at a rate less than
a. Interest earned on tax-free municipal bonds is free of federal income taxes and may also be free
c. When you sell a personal residence, any capital gain is deferred if another residence is bought
within two years. Individuals can exclude $250,000 of the accumulated capital gains from the
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20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
7. a. A put hedge locks in profits but does not exclude potential additional price
appreciation, as does a short sale. Purchasing a put option on shares the investor owns guarantees
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
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
b. Keogh plans are retirement plans that permit self-employed people to contribute up to 20% of
their earned income, up to a $53,000 maximum (in 2015), to a retirement plan on a pretax basis.
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 $5,500 for an
9. a. Traditional deductible IRA. These IRAs are self-directed, tax-deferred retirement
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
c. Nondeductible IRA. A nondeductible IRA allows taxpayers who fail to meet the income cutoffs
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Chapter 2 Securities Markets and Transactions 21
d. SIMPLE IRA. A retirement savings plan for small business owners that does not include the costs
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
b. Section 529 College Savings Plans are state-sponsored, tax-deferred college savings plans with
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
Investments that have good tax-sheltering qualities, such as municipal bonds, should not be used for
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
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
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
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
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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.
14. An annuity is a series of payments guaranteed for a number of years or over a lifetime. All funds
a. A single-premium annuity is one in which the purchaser pays a single lump sum for the contract
b. An immediate annuity is a contract under which payments to the annuitant begin as soon as it is
c. A fixed annuity is written so that once a payment schedule is selected, the amount of the monthly
b. The minimum guaranteed interest rate is the minimum interest rate on contributions that the
c. The payout is the investment return provided by an annuity contract, realized when the
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
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Chapter 2 Securities Markets and Transactions 23
The tax-sheltered annuity is an annuity contract available to certain employees of institutions such
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
17. The principal positive feature of deferred annuities is that they allow the investor to accumulate
Some negative aspects of deferred annuities are the lack inflation protection and the high sales
Before buying an annuity, an investor should analyze the prospectus and compare it against any
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
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
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
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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
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