Basic Method
In the Basic Method of tax optimization, the Optimizer adjusts asset level returns and standard deviations to explicitly consider the effect of marginal income and capital gains taxes. The key to the Basic Method of tax optimization is that total return consists of several components (the first two components sum to the yield):
1. ordinary interest and non-qualified dividend income
2. qualified dividend income
3. realized short-term capital gain or loss
4. realized long-term capital gain or loss
5. unrealized gain or loss
The Basic Method adjusts the return of each component separately and then combines them to find the after-tax return of each asset. It also adjusts the risk based on how taxes affect the returns, lessening large gains, and ameliorating large losses. However, the Optimizer treats correlations as if they do not change with taxation.
Enabling the Basic Tax Method in the Taxes Menu calls up the Taxes Worksheet. Begin by entering the federal and state tax rates on different income types in the Tax Rates Table.
The Pre-Tax Return, Pre-Tax Standard Deviation, and Pre-Tax Yield columns populate from the data entered on the Inputs Worksheet. If you have not entered yields on the Inputs Worksheet, do so now. Several other components of capital gains and income calculation must be entered directly on the Taxes Worksheet. As you enter data, the protected columns update automatically; the calculations are explained below.
Capital Gains Columns
Pre-tax capital gains are the portion of the pre-tax total return that came from capital gains or losses. The Pre-Tax Capital Gains column automatically populates by subtracting the yield from the return. Correct or complete as necessary. Pre-tax capital gains and losses split into three elements that are entered separately: unrealized, short term, and long term capital gains. Begin by identifying what portion of the pre-tax total return comes from capital gains/losses, generally by subtracting the pre-tax yield from the pre-tax total return. Enter the percentage of pre-tax capital gains that comes from assets held for less than a year in the Short Term Capital Gains column of the appropriate asset. Enter the percentage of the pre-tax capital gains/losses that come from assets held for at least a year in the Long Term Capital Gains column of the appropriate asset. The Unrealized Capital Gains column populates by subtracting the short term capital gains and the long-term capital gains from 100%. The Combined Cap Gain Tax Rate column populates according to the following formula:
ST Capital Gains x (Federal + State ST Tax Rates) + LT Capital Gains x (Federal + State LT Tax Rates).
The Optimizer applies this rate in order to display the after-tax capital gains total return in the After Tax Capital Gain Column.
Income Assumptions Columns
Bearing in mind that the Optimizer assumes a single period optimization, indicate whether federal and state taxes apply to each asset in the Income Assumptions columns. Entering "No" prevents the Optimizer from applying that particular tax to the asset. You can designate an asset as subject to federal tax, state tax, neither tax, or both taxes. Tax deferred assets, if any, are automatically listed as tax free.
Income Columns
Ordinary income (non-qualified, such as from interest) and income from qualified dividends have separate tax rates. Enter the portion of the yield attributable to qualified dividends in the “% of Yield as Qualified Dividend” column. The “% of Yield as Ordinary Income” subtracts the qualified dividend from each asset's yield. The Combined Income Tax Rate column displays the weighted average of the federal and state tax rates for interest and dividends. The After Tax Yield column populates with the total yield after taxes.
Additional Columns
The After-Tax Standard Deviation column displays the impact of taxes on standard deviation. Tax bills offset large gains, and tax gains offset large losses. In tax optimization, this effect of taxes should not be missed. For most investable assets, the standard deviation of the yield is negligible compared to the standard deviation of the capital gains. Therefore, the Optimizer calculates the after-tax standard deviation with the following approximation: the pre-tax standard deviation multiplied by (100% - Combined Cap Gain Tax Rate). The After-Tax Return column aggregates the after-tax returns, both capital gains and income. The Effective Tax Rate column presents the impact of taxes on returns: 1 - (After Tax Return)/(Pre-Tax Return).
Results
The resulting tax-adjusted risk and return estimates appear on the Results Worksheet as well as the Taxes Worksheet. When enabled, the Optimizer uses the adjusted risk and return estimates for optimization.