Tax Free Gifts

CFA Level III
#1

Can someone explain whats going on in page 277 - 278 (Volume 2).

I get the main point that its worthwhile to take advantage of periodic transfers which are tax free (ie in this case 13,000 or less) so that you can effectively transfer the wealth without having to pay the tax on the transfer at the end. The only tax paid is on the reutrns earned on the 13,000 paid each year … but no tax on contributing 13,000 each year.

What I don’t get is the example they use to illustrate this idea, specifically the calculations. Annual Payment is 13,000. After Tax Real Return is 4.125% ((8.00% - 2.5% for inflation) x (1 - 0.25 annual tax)). This stream has a future value of 744,516.51. It says on page 277 that the gifting program transfers 640,000.

Would like someone to explain where I’m wrong.

#2

you are not applying taxes on inflation ( inflation is not tax-exempt)… taxes is on nominal rate.

8%*(1-0.25) = 6%

then you take out inflation 1.06/1.025 = 3.4146%

If It was me the number would have been 661 000$ but it looks like they used this formula for whatever reason :

N = 29, i = 3.4146%, PV = 0 PMT = 13 000, CPT FV.

you get 627 000$, you add 1 last pmt of 13 000 and you get their 640 000. I am still clueless why they are doing it that way, on the exam I would use N = 30 and put 660 000

#3

At the bottom, it says the total wealth transfered is 695,000 … where did that come from?

#4

they take the values of Exhibit 4, look at the note of the chart, it says 5% real return. My guess is that the calculation is base on some other nominal return than 8%. it is just poorly written.

#5

for 1st year: 13000 ->

no tax = 13000*(1.08)^31 = 141,280

taxed = 13000*(1.06)^31 = 79145

Tax amount at end = (141280 - 13000) * 0.25 = 32070

Do this for each period.

Sum all no tax = 1,717,736

Sum one time tax at end across all period = 331,934

Now applying inflation factor

1,717,726 / (1.025^31) = 798,944

331,934 / (1.025^31) = 154,387

Difference = 644,557

#6

but it says 8 percent nominal return that is taxed at 25 percent annually

#7

taxed = 13000*(1.06)^31 = 79145 --> 8 *(1-0.25) = 6%

Tax amount at end = (141280 - 13000) * 0.25 = 32070

#8

im confused CPK, i dont see where you are using your 79 145.

your calculation are based on the sum of a 1 time tax at the end, am I wrong?

taxed = 13000*(1.06)^31 = 79145 --> 8 *(1-0.25) = 6%

Tax amount at end = ( 141280 - 13000) * 0.25 = 32070

141280 - 32070 is different from 79145

#9

the 79145 is not relevant though for this accumulation calculation.

Your tax rate is 25% - on the difference between a full accumulation at 8% = 141280 and what was deposited in the beginning of period. This is for year 1 (where everything accumulates for 31 years).

For year 2 - corresponding numbers:

  • Year,Contib,EndAmount,NoTaxAccumulation,OneTimeTaxAtEnd
  • 1,13000,79145,141280,32070
  • 2, 13000,74665,130815,29455
#10

I did the calculation again and got 645,605.04.

First Payment: 13,000 x (1.06) ^ 29 = 70,439

do this for each payment until the final year, which is simply 13,000 without any appreciation. Total is 1,027,756

You then have to adjust each payment for inflation - divide by (1.025^n+1). The sum of these inflation adjusted cashflows is 645,605.04 … close enough.

I guess the gift is like a regular annuity (wait 1 year until the first payment is received) so u start compounding with 29 years. The ending future value needs to be discounted back 30 years however at the rate of inflation. Not sure if this is the correct method but the figure seems reasonable. I doubt this calculation will come up becuase its rather tedious and was only used to illustrate a point … which it did very poorly. On top of that, where does 695,000 come from?

The important point to take home, holding onto this asset until you die will incurr an estate tax while periodically splitting it into mini-payments over time means you can effectively transfer the same amount without estate tax.