CHAPTER 4
FINANCIAL PLANNING, TAXATION, AND THE EFFICIENCY OF
FINANCIAL MARKETS
Teaching Guides for Questions and Problems in the Text
QUESTIONS
4-1. The first step is specifying financial objectives; then the individual needs to identify
sources of funds, take an inventory of assets owned and liabilities owed. The stability of
the individual’s employment and the tax environment also play a role in the construction of
a financial plan. Anticipated changes in any of these factors affect the construction of
financial plans.
4-2. a. mortgage – balance sheet
b. principal repayment – cash budget
c. dividends payments (received) – cash budget
d. stock – balance sheet
4-3. A tax shelter (1) reduces taxes, (2) defers taxes, or (3) avoids taxes. Reductions occur
when the taxpayer is permitted to exclude something from tax (e.g., the deduction of property
4-4. A capital gain is the appreciation in the value of a capital asset, which is an asset not
used in the production of ordinary income for the taxpayer. For most individuals, stocks and
bonds are capital assets. (Stocks and bonds would not be capital assets for market makers
who earn ordinary income through their purchases and sales of stocks and bonds.)
Taxes are levied on capital gains only after they are realized. If the asset has appreciated but
has not been sold so that the capital gain has not been realized, there are no capital gains
taxes.
4-5. a. As of 2015, the maximum tax rate on dividend income was 15 percent except for
individuals in the highest tax bracket, so dividend income is a tax shelter. (Prior to 2003,
dividends were taxed as ordinary income and not illustrative of a tax shelter.)
b. Interest on a savings account is fully taxed and is not an illustration of a tax shelter.
(Interest could be shelter from current taxation if the payments are made to a tax-deferred
pension plan.)
4-6. IRA, 401(k), and Keogh plans are all tax-deferred retirement plans. The Keogh plan
applies to the self-employed. The 401(k) is a voluntary salary reduction plan and is generally
offered by firms in addition to or in lieu of regular pension plans. A regular IRA is a pension
plan for individuals not covered by an employee sponsored pension plan. The contributions to
a traditional IRA are tax deductible. Contribution to an IRA may also be fully deductible for
individuals who are covered by pension plans but who earn only modest amounts of income.
4-7. The primary difference between a deductible IRA and a Roth IRA is the timing of the tax
shelter. In a traditional (deductible) IRA, the contributions are deductible from income before
tax. With the Roth IRA, contributions are not deductible and are made with after-tax dollars.
With a deductible IRA all distributions are subject to income tax. With a Roth IRA,
distributions are not taxed.
If the individual anticipates being in a lower tax bracket when funds will be withdrawn, that
argues for the deductible IRA. The reverse occurs if the tax rate is anticipated to be higher
when the funds will be withdrawn. In that case, the Roth IRA has a larger tax shelter.
4-8. Taxes laws may change every year. This question asks the student to determine current
tax rates, the maximum amounts that may be contributed to retirement accounts, and the
deductibility of charitable contributions.
a. Federal income tax brackets are adjusted annually for the rate of inflation. In recent years
this adjustment has been modest because of the modest rate of inflation. The adjustment,
b. The maximum allowable contribution to an IRA (both deductible and non-deductible
c. As of 2015, the maximum rates on short-term and long-term capital gains were 39.6% and
d. Contributions to charities are tax deductible, so presumably the contributions to an alumni
4-9. The efficient market hypothesis does not say that the investor will not outperform the
market. Obviously during a specific period some investors do outperform the market.
However, the efficient market hypothesis asserts that these particular investors will
probably not outperform the market during the next time period. Thus the individual cannot
expect to outperform the market consistently over an extended period of time even though
over a short period of time some investors will outperform the market.
4-10. Even if securities markets are efficient, that does not answer the question “How
efficient?” There are three forms of the efficient market hypothesis. The weak form
suggests that the use of technical analysis of trading patterns or price patterns will not lead
to superior portfolio performance. The semi-strong form adds to the weak form that the use
of any known public information will not lead to superior investment results. Hence
studying such information as a firm’s financial statements or economic conditions and
trends does not produce superior investment performance. The strong form adds that even
studying and analyzing inside information does produce superior investment results.
4-1. a. Profits on the sales (all are short-term):
ABC $28,600 – 24,500 = $4,100
b. Profits on the sales:
ABC $28,600 – 34,600 = ($6,000)
For a joint return, $3,000 of the loss ($1,500 for married couples filing single returns) may be
used to offset income from other sources. The tax savings is
4-2. This problem is concerned with the offsetting of long-term and short-term capital gains.
The rule is that long-term losses are initially used to offset long-term gains and any remaining
long-term losses are used to offset short-term gains. Short-term losses are initially used to
offset short-term gains and any remaining short-term losses are used to offset long-term gains.
If there is a net capital loss after netting out short-term and long-term capital gains and losses,
the loss is used up to $3,000 against ordinary income.
a. The net short-term is taxed at 33 percent and long-term capital gain is taxed at 15 percent.
b. The long-term loss of $4,000 offsets the short-term gain of $3,000 for a net long-term loss
c. The short-term loss of $3,000 is used to offset the $4,000 long-term gain, leaving a net
d. The long-term loss of $2,000 is used to offset the $3,000 short-term gain, leaving a net
e. The short-term loss of $4,000 is used to offset the $3,000 long-term gain for a net
f. The net long-term and short-term losses are added and used to offset ordinary income. The
g. The net long-term and short-term losses are added and used to offset ordinary income.
4-3. This set continues problem 2 (except for a lower income tax bracket) and provides more
practice.
a. ZYX is sold for a $1,300 short-term gain and WER is sold for a long-term $300 loss. The
b. ZYX is sold for a $2,300 short-term loss. WER is sold for a $700 long-term gain, and DFG
c. ZYX is sold for a $900 long-term loss. WER is sold for a $1,300 long-term loss, and DFG
d. This problem illustrates the wash sale. The stock is repurchased on October 10, which is
less than thirty-one days after the sale on October 2, which generated the $2,000 loss. The
4-4. a. The $2,000 contribution to the 401(k) plan reduces income by $2,000 and saves $500.
b. The $2,000 contribution to the Roth IRA does not reduce income and there is no current tax
4-5. a. The price appreciation from $2,000 to $23,000 over twenty years produces an annual
rate of growth of 13 percent. This is another illustration of time value:
$2,000(FVIF) = $23,000
FVIF = $23,000/$2,000 = 11.50
Using the table for the future value of $, locate the interest factor for 20 years and determine
the rate to be between 12 and 14 percent. (PV = -2000, PMT = 0; N = 20; FV = 23000, and I =
? = 12.99.)
b. If the $23,000 is withdrawn from the IRA, the tax is $23,000(0.35) = $8,050. The tax rate is
the rate on income and not the rate for long-term capital gains.
4-6. $3,000 grows into
$3,000(FVAIF) = $3,000(36.786) = $110,35
4-7. a. The $10,000 in the IRA grows to
The additional IRA contributions grow to
$2,000(15.193) = $28,974.
(PV = 0; I = 9; N = 10; PMT = -2000, and FV = ?
= 30385.86.)
The total in all the accounts (using the interest tables) is $23,670 + 118,350 + 30,386 =
$172,406.
b. If $17,000 is withdrawn annually, first determine the interest factor: $172,406/$17,000 =
10.14. If 10.14 is the interest factor for the present value of an annuity at 9%, the expected life
c. If the individual to withdraws the funds over eighteen years, the annual withdrawal is
4-8. This problem is designed to demonstrate why IRA contributions should be made as early
in a worker’s life as possible. The terminal value for Bob:
The terminal value for Mary:
$2,000(14.486)(2.159) + 1,000(14.486) = $77,037.
The difference in amount earned: $77,037 – 60,247 = $16,790.
Point out that the interest factors for both are the same. 14.486 is the interest factor for the
4-9. This problem illustrates the importance of placing the funds in the name of the younger
spouse in order to take advantage of the longer period during which the earnings grow tax
deferred.
Mike is age 65, and the funds continue to earn interest tax deferred until he starts withdrawing
the funds at age 70. So the account grows to:
Mike is now 70 and Mary is 65. Since their expected life is 85 years, they may withdraw the
funds over 20 years. The annual withdrawal is
OBJECTIVE: Using retirement plans to reduce current federal income taxation.
BACKGROUND: Financial planning often involves combining planning and portfolio
strategies for retirement and strategies for reducing current federal income taxes. Since
tax-deferred retirement plans are a major federal income tax shelter, you have selected two
individuals to illustrate potential tax strategies using retirement accounts.
ANSWERS TO THE SPECIFIC QUESTIONS
1. It is doubtful that Mary can set up an IRA and deduct the contribution, since reading
Jason, who is self-employed and is not covered by a pension plan, may set up and deduct the
contributions. This, however, may not be the best strategy, since more may be contributed to a
retirement account (and deducted from income) if he establishes a Keogh account. (Be certain
the point out that an IRA is still better than NO tax-deferred retirement account.)
2. Since Mary is employed, she cannot set up a Keogh account (unless she has additional
self-employed income). Since Jason is self-employed, he may set up a Keogh account. While
3. The answer to this question depends on how much may be contributed, the extent to which
the employer matches contributions to the 401(k) plan, and the tax deductibility of the
4. Not only are the contributions not taxed when they are made, the income generated by the
5. Funds withdrawn from a 401(k) and a Keogh account are taxed as income. If the
distribution occurs before the individual is 59 1/2 years old, there may also be penalties.
6. This question continues the preceding question by asking the student to think about
whether stock that may generate capital gains should be included in the tax-deferred pension
plan. If the individual buys a stock with funds in the account and sells the stock for a gain
7. While the actual purchase price of the annuity will not be tax deductible, income generated
8. The essence of this question is that individuals who are contemplating retirement should
place as much as they can in tax-deferred retirement accounts are soon as they are eligible. In