Deck 18: Taxes and Investment Planning

Question 1

The Deferred Model investment outperforms the Current Model investment if interest rates and tax rates are constant over time because the interest on the Deferred Model investment grows tax free until withdrawal.

Answer 1

True

Question 2

The nondeductible traditional IRA is a classic example of the Pension Model.

Answer 2

False

Question 3

In the Deferred Model,investment earnings are taxed at the end of the investment period.

Answer 3

True

Question 4

Savings accounts and money market funds are examples of investments taxed under the Current Model.

Question 5

In the Current Model,investment earnings are taxed currently.

Question 6

The Roth IRA is an example of the Pension Model.

Question 7

One of the characteristics of the Exempt Model is that earnings on the investment are exempt from explicit taxation.

Question 8

Investments conforming to the Current Model provide no deferral advantages because earnings are taxed currently.

Question 9

In the Pension Model,the initial investment is deductible or excludable from gross income,and investment earnings are taxed currently.

Question 10

One characteristic of the Exempt Model is the fact that,like the Current and Deferred Models,only after-tax dollars are invested.

Question 11

In the Exempt Model,the earnings are exempt from tax until the end of the investment period.

Question 12

The Deferred Model offers two levels of tax deferral-the original contribution escapes current taxation as do the earnings on the underlying investment.

Question 13

A single taxpayer earns a salary of $6,000.If he is taxed with a 10% flat rate,he has $5,400 of after-tax dollars available to invest.

Question 14

Examples of the Exempt Model include deductible IRAs,H.R.10 (Keogh)plans,Sec.401(k)plans,and tax deferred annuities.

Question 15

When given a choice between making a contribution to a Roth IRA or to a nondeductible traditional IRA,the taxpayer should choose the Roth IRA.

Question 16

In the Deferred Model,only after-tax dollars are invested.

Question 17

One characteristic of the Pension Model is the fact that,like the Current and Deferred Models,only after-tax dollars are invested.

Question 18

Under the Pension Model,the entire accumulation,not just the earnings,is taxed at the end of the investment horizon.

Question 19

Employer-sponsored qualified retirement plans and deductible IRAs fit the Pension Model.

Question 20

A taxpayer in the 25% marginal tax bracket invests $1,000 at 10% interest before taxes.At the end of year one,the taxpayer will have accumulated after-tax dollars of $1,075.

Question 21

If "R" equals the before-tax rate of return and "t" equals the investor's marginal tax rate,then the after-tax rate of return represented by "r" can be expressed as

A)r = R(1 - t).
B)r = R(1 + t).
C)r = (1 + t)^R.
D)r = R - t.

Question 22

The Current Model provides the future value of an investment having which of the following characteristics?

A)only after-tax dollars are invested
B)only before-tax dollars are invested
C)the earnings on the investment are taxed at the end of the investment period
D)investment earnings are exempt from taxation

Question 23

Rich,an individual investor,lives in a land of no taxation and receive a $10,000 bonus.He invests this amount in a bond that pays interest of 4% per year and holds the bond for 5 years,reinvesting the interest annually at the same 4% return.At the end of 5 years the $10,000 original investment accumulates to

A)$10,400.
B)$12,625.
C)$12,763.
D)$12,167.

Question 24

The investment models discussed in the text include all of the following except for

A)the Deferred Model.
B)the Pension Model.
C)the Exempt Model.
D)the Non-Current Model.

Question 25

A flow-through entity's primary characteristic is that income escapes taxation at the entity level and flows-through to be taxed at the ownership level.

Question 26

Nolan earns a salary of $80,000 and has a flat tax rate of 28%.The amount of after-tax dollars he has to invest is

A)$22,400.
B)$57,600.
C)$56,000.
D)$80,000.

Question 27

The Current Model most closely describes a flow-through entity while a variation of the Deferred Model describes a C corporation.

Question 28

In the Pension Model,

A)investment earnings are taxed currently.
B)investment earnings are exempt from explicit taxation.
C)investment earnings are taxed at the end of the investment period.
D)the initial investment is deductible or excludable from gross income,and the investment earnings are taxed at the end of the investment period.

Question 29

Flow-through entities include partnerships,limited liability companies,limited liability partnerships,and C corporations.

Question 30

The Flow-Through Model also applies to a sole proprietorship.

Question 31

Given that D_n is the amount of deferred compensation received in lieu of $1 currently,then if the employee's indifference level of D_n exceeds the employer's indifference level of D_n,the employee must accept current salary because the employer will not pay the employee's required deferred compensation.

Question 32

Kate can invest $4,000 of after-tax dollars (AT$)directly in a taxable bond outside an IRA,or she can contribute the $4,000 to a nondeductible IRA and invest in the same bond through the IRA vehicle.In either case the bond yields an annual 3% before-tax rate of return (BTROR).Kate's marginal tax rate is 15%,and she expects it to remain so for the entire investment horizon of 25 years.What is the after-tax accumulation for the "bond outside the IRA" after 25 years?

A)$5,585
B)$7,507
C)$8,375
D)None of the above.

Question 33

Heidi invests $1,000 in a taxable bond for 5 years that earns 4% interest per year.Her marginal tax rate is 15%.What is her after-tax accumulated investment at the end of year 5?

A)$1,182
B)$1,143
C)$1,020
D)$1,762

Question 34

In the Current Model,

A)investment earnings are taxed currently.
B)the initial investment is deductible or excludable from gross income,and the investment earnings are taxed at the end of the investment period.
C)investment earnings are exempt from explicit taxation.
D)investment earnings are taxed at the end of the investment period.

Question 35

When evaluating current salary versus deferred compensation,an employer considers the fact that a current salary is deducted in the current year and obtains an immediate tax benefit.

Question 36

Miles invests $20,000 in a taxable bond for 5 years that earns 5% interest per year.His marginal tax rate is 15%.What is his after-tax accumulated investment at the end of year 1?

A)$20,850
B)$21,000
C)$21,700
D)$22,000

Question 37

In the Deferred Model,

A)investment earnings are taxed currently.
B)investment earnings are exempt from explicit taxation.
C)investment earnings are taxed at the end of the investment period.
D)the initial investment is deductible or excludable from gross income,and the investment earnings are taxed at the end of the investment period.

Question 38

Given a choice between a fully-taxable investment and a tax-favored investment,investors will prefer the tax-favored investment,assuming the two investments are equally risky.

Question 39

The C Corporation Model is a variation of the Flow-Through Model,where taxation occurs at both the entity and the owner levels.

Question 40

In the Exempt Model,

A)investment earnings are taxed currently.
B)investment earnings are exempt from explicit taxation.
C)investment earnings are taxed at the end of the investment period.
D)the initial investment is deductible or excludable from gross income,and the investment earnings are taxed at the end of the investment period.

Question 41

The formula for the after-tax accumulation (ATA)for the Exempt Model is

A)ATA = AT$ (1 - t)ⁿ.
B)ATA = AT$ (1 + t)ⁿ.
C)ATA = AT$ (1 + R)ⁿ.
D)ATA = AT$ (1 - R)ⁿ.

Question 42

At the beginning of year 1,Sandeep invests $10,000 in a money market fund that pays a 3% annual return before taxes.Sandeep's marginal tax rate is 25%,and he allows the after-tax earnings to remain in the money market fund.That is,he withdraws only enough cash to pay the taxes on the earnings.What is his after-tax accumulation at the end of year 2?

A)$10,455
B)$10,609
C)$10,690
D)None of the above

Question 43

Sylvia makes a one-time $2,000 deductible contribution into a deductible traditional IRA account,which will earn 8% annually before taxes.Twenty-five years later,at age 65,she withdraws all of the accumulation from the IRA when she is in the 15% marginal tax bracket.What is the total of her after-tax accumulated proceeds from the IRA?

A)$6,000
B)$8,541
C)$11,642
D)$13,697

Question 44

The Flow-Through Model used for S corporations and partnerships is an application of the

A)Pension Model.
B)Current Model.
C)Deferred Model.
D)Exempt Model.

Question 45

Which of the following is a classic example of the Deferred Model?

A)a deductible traditional IRA
B)a 401(k)plan
C)a H.R.10 (Keogh)plan
D)a nondeductible traditional IRA

Question 46

Common examples of the Pension Model include all of the following except for

A)H)R.10 (Keogh)plans.
B)401(k)plans.
C)Nondeductible traditional IRAs.
D)tax deferred annuities or 403(b)plans.

Question 47

Which of the following characteristics belong(s)to the Exempt Model?

A)Only after-tax dollars are invested.
B)Only tax-free dollars are invested.
C)Earnings on the investment are exempt from explicit taxation.
D)both A and C

Question 48

The Deferred Model has all of the following characteristics except for

A)only after-tax dollars are invested.
B)the earnings on the investment are not taxed annually.
C)the accumulated earnings are taxed at the end of the investment horizon.
D)the Deferred Model will not outperform the Current Model given equal BTRORs and constant tax rates.

Question 49

If t₀ is the tax rate in Year 0,t_n is the tax rate in Year n,and ATA is after-tax accumulation,then which one of the following does not hold true?

A)if t₀ = t_n,ATA per Exempt Model = ATA per Pension Model
B)if t₀ > t_n,ATA per Exempt Model < ATA per Pension Model
C)if t₀ < t_n,ATA per Exempt Model > ATA per Pension Model
D)if t₀ > t_n,ATA per Exempt Model > ATA per Pension Model

Question 50

Flow-through entities include all of the following types of entities except:

A)partnerships.
B)C corporations.
C)S corporations.
D)limited liability companies (LLCs).

Question 51

The Pension Model has all of the following characteristics except for

A)before-tax dollars are invested.
B)the annual earnings on the investment grow at the before-tax rate of return.
C)only the accumulated earnings are taxed at the end of the investment horizon when the investor cashes out of the investment.
D)the entire accumulation is taxed at the end of the investment horizon when the investor cashes out of the investment.

Question 52

Will invests $20,000 of after-tax dollars (AT$)in tax-exempt municipal bonds which yield 5% per year.He reinvests the interest in the same bonds and holds the bonds for two years.Will's marginal tax rate is 25%.What is his after-tax accumulation at the end of two years?

A)$21,000
B)$21,528
C)$22,000
D)$22,050

Question 53

Willa is considering receiving either $20,000 of current salary or $30,000 of deferred compensation in two years.Her current tax rate is 35%,but she expects her tax rate to be 25% two years from now.Willa can invest any after-tax current salary at a 6% ATROR.If she receives the current salary and invests the after-tax amount,her investment will accumulate to

A)$16,854.
B)$14,607.
C)$22,472.
D)None of the above.

Question 54

State and local government obligations such as municipal bonds are classic examples of which model?

A)Deferred Model
B)Exempt Model
C)Current Model
D)Pension Model

Question 55

The C Corporation Model is a variation of the

A)Current Model.
B)Pension Model.
C)Exempt Model.
D)Deferred Model.

Question 56

Jan can invest $4,000 of after-tax dollars (AT$)directly in a taxable bond outside an IRA,or she can contribute the $4,000 to a nondeductible IRA and invest in the same bond through the IRA vehicle.In either case the bond yields an annual 4% before-tax rate of return (BTROR).Jan's marginal tax rate is 15%,and she expects it to remain so for the entire investment horizon of 25 years.What is her annualized after-tax rate of return (annualized ATROR)for the "bond inside the IRA"?

A)3)6%
B)4)5%
C)4%
D)None of the above.

Question 57

Judy is considering receiving either $20,000 of current salary or $40,000 of deferred compensation in 12 years.Her current tax rate is 33%,but she expects her tax rate to be 15% 12 years from now.Judy can invest any after-tax current salary at a 6% ATROR.If she receives the deferred compensation,her investment will accumulate to

A)$26,800.
B)$34,000.
C)$36,000.
D)$40,000.

Question 58

Charlene can invest $4,000 of after-tax dollars (AT$)directly in a taxable bond outside an IRA,or she can contribute the $4,000 to a nondeductible IRA and invest in the same bond through the IRA vehicle.In either case the bond yields an annual 7% before-tax rate of return (BTROR).Charlene's marginal tax rate is 20%,and she expects it to remain so for the entire investment horizon of 25 years.What is her annualized after-tax rate of return (annualized ATROR)for the "bond outside the IRA"?

A)5)6%
B)6%
C)6)5%
D)7%

Question 59

The general form of the annualized after-tax rate of return (annualized ATROR)can be expressed as

A)r_ann = [(1 + R)ⁿ(1 - t_n)+ t_n]^1/n - 1.
B)r_ann = [(1 - R)ⁿ(1 - t)+ t]^1/n - 1.
C)r_ann = [(1 + R)ⁿ(1 + t)+ t]^1/n - 1.
D)r_ann = [(1 + R)ⁿ(1 + t)- t]^1/n - 1.

Question 60

Vidya can invest $5,000 of after-tax dollars (AT$)directly in a taxable bond outside an IRA,or he can contribute the $5,000 to a nondeductible IRA and invest in the same bond through the IRA vehicle.In either case the bond yields an annual 5% before-tax rate of return (BTROR).Vidya's marginal tax rate is 15%,and he expects it to remain so for the entire investment horizon of 20 years.What is the after-tax accumulation for the "bond inside the IRA" after 20 years?

A)$12,027
B)$11,277
C)$10,062
D)None of the above.

Question 61

Earl invests $7,000 in a tax-exempt bond yielding 4% which matures in 15 years.What is Earl's after-tax accumulation at maturity?

Question 62

Rachel invests $5,000 in a money market account which earns a 5% before-tax return.Rachel has a 20% marginal tax rate.Rachel makes the one-time investment and leaves the funds in the account for 10 years.She allows all after-tax earnings to remain in the account.What is her after-tax accumulation after 10 years?

Question 63

Discuss the decision rules for current salary versus deferred compensation.

Question 64

Ken invests $10,000 in a deductible IRA which he will hold for 10 years.His current tax rate is 30% and he estimates that his tax rate will remain the same upon withdrawal.He will not be subject to the 10% penalty tax.Assume that the IRA will yield a before-tax return of 10%.What is the after-tax accumulation?

Question 65

Sophia's employer is considering paying her either $20,000 of current salary or $40,000 of deferred compensation in 12 years.Her employer's current tax rate is 34%,but the employer expects its tax rate to be 25% 12 years from now.The employer's ATROR is 11%.If the employer waits and pays the deferred compensation,its after-tax deferred compensation expense projected to Year 12 is

A)$20,000.
B)$26,400.
C)$30,000.
D)$40,000.

Question 66

Jorge contributes $5,000 to a traditional nondeductible IRA in the current year and makes no subsequent contributions.Assume that the investment in the IRA yields 6% per year and that Jorge allows his investment to accumulate for 20 years.At the end of twenty years,he withdraws all of the amounts from the IRA when his marginal tax rate is 30%.What is his after-tax accumulation?

Question 67

Elise contributes $1,000 to a deductible IRA.Her investment will earn 10% annually before taxes,and she will withdraw the accumulated amounts from the IRA after 20 years.She expects her tax rate to be 25% at that time and will not be subject to the 10% on early distributions.What is Elise's after-tax accumulation in the IRA?

Question 68

If a fully-taxable bond yields a BTROR of 8% (R_b = 8%)and a tax-exempt bond of similar risk earns a BTROR of 5% (R_f = 5%),then the implicit tax is

A)3%.
B)5%.
C)8%.
D)None of the above.

Question 69

Brianna purchases stock for $8,000.The stock appreciates (grows)at a 6% rate before taxes.Brianna sells the stock ten years later for $14,327.Brianna has a 39.6% marginal tax rate,but the stock sale is a LTCG taxed at 20%.Ignore the 3.8% Medicare surtax on net investment income.What are Brianna's after-tax proceeds?

Question 70

In a progressive tax system,an investor can benefit from tax-exempt bonds when

A)the investor's marginal tax rate is equal to the marginal investor.
B)the investor's marginal tax rate exceeds that of the marginal investor.
C)the investor's marginal tax rate is less than that of the marginal investor.
D)None of the above.

Question 71

What are the characteristics of the Pension Model?

Question 72

Which of the following concerning implicit taxes and clienteles is not true?

A)Market forces drive down the BTROR of tax-favored assets.
B)The reduced return of tax-favored assets is an implicit tax.
C)Investors whose tax rate exceeds that of the marginal investor can reap some benefit through the clientele effect.
D)Marginal investors will always benefit from the implicit tax on tax-favored investments.

Question 73

Given that D_n is the amount of deferred compensation received in lieu of $1 currently,which one of the following decision rules can the employee and the employer apply when evaluating whether deferred compensation is preferable to current salary?

A)If the employee's indifference level of D_n exceeds the employer's indifference level of D_n,the employer will pay deferred compensation up to the employee's indifference level.
B)If the employee's indifference level of D_n is less than the employer's indifference level of D_n,the employee will only receive a current salary because the employer will not pay the employee's required deferred compensation.
C)If the employee's indifference level of D_n is less than the employer's indifference level of D_n,the employer can pay deferred compensation up to its indifference level.
D)None of the decision rules in A,B,or C above hold true.

Question 74

Compare the characteristics of the Current and Deferred Models.

Question 75

If a fully-taxable bond yields a BTROR of 10% (R_b = 10%)and a tax-exempt bond of similar risk earns a BTROR of 7.5% (R_f = 7.5%),then the implicit tax rate is

A)25%.
B)75%.
C)10%.
D)None of the above.

Question 76

Nontax issues to consider when evaluating current salary versus deferred compensation include

A)the employee may need the cash now.
B)deferred compensation carries some risk.
C)deferred compensation may,depending on the contract,lock the employee into continued employment.
D)All of the above are issues to be considered.

Question 77

The difference between the BTRORs of fully-taxable and tax-favored investments is called

A)an explicit tax.
B)an implicit tax.
C)an effective tax.
D)a marginal tax.

Question 78

Cooper can invest $10,000 after-tax dollars in a taxable bond either outside or inside a traditional nondeductible IRA.He will hold the investment for ten years.The bond yields 6% before taxes and Cooper's marginal tax rate is 33%.If he invests directly in the bond,he will withdraw an amount of interest each year sufficient to pay taxes and leave the remaining interest in the investment.What are the after-tax accumulations in the bond and in the IRA? Cooper will not be subject to the 10% penalty tax when the IRA withdrawal occurs.

Question 79

Melanie is in the 39.6% tax bracket and is ineligible to make deductible or Roth IRA contributions.Nevertheless,she wishes to contribute $5,500 to a traditional nondeductible IRA.How much taxable salary must she earn to have $5,000 left for the contribution?