Tax-exempt account

[FrankCFA]

In a tax-exempt account, contributions to the account are made with:

A) after-tax funds and do not reduce the investor’s current tax bill.
B) pre-tax funds and reduce the investor’s current tax bill.
C) after-tax funds and reduce the investor’s current tax bill.

Seems like an easy concept but I’m struggling to understand it…

 

[cpk123]

c here as well

Quote:
Because contributions to a tax-exempt account are tax- able, a pretax investment is reduced by taxes such that the after-tax investment is (1 − T0), where T0 is the tax rate applicable to the initial pretax contribution. The future value of a pretax dollar invested in a tax-exempt account is therefore (1 − T0)(1 + r)n. This expression reflects that taxes reduce the initial investment.

 

[Galli]

^ yep.
Tax-exempt means the return itself is not taxable yet the income you earn in order to fund the investment is taxable.

 

[kjsgbp]

I think A…
The current tax bill is not reduced since the income used to invest in the tax exempt account is taxed as usual, thus, not reducing the current tax bill. Can someone explain why this is wrong, or maybe Frank can post an answer?

 

[FrankCFA]

Kjsgbp is right.

Answer: A

Kaplan Rationale:
The tax benefit for a tax-exempt account occurs when the funds are withdrawn.

LOS 10.e: Discuss the tax profiles of different types of investment accounts and explain their impact on after-tax returns and future accumulations.
Tax-deferred account (TDA) contributions reduce the taxpayer’s current taxes (front-end tax benefit); returns accrue tax free and are taxed when withdrawn.

FVIF_TDA = (1 + R)^N *(1 − TN)
Tax-exempt account contributions are made with after-tax funds. Returns accrue and are withdrawn tax free (back-end tax benefit).

FVIF_TEA = (1 + R)^N
Assuming equal returns and horizons, to determine which account will have the highest future value (FV), compare the current (T0) and future tax rates (TN):

If today’s tax rate is lower, pay the taxes now and put after-tax funds into a TEA.
If the expected future tax rate is lower, wait to pay taxes by putting pretax funds into a TDA now and pay taxes later.
If the two rates are equal, it will not matter which account is used. (Unless the contribution amount to both is equal. TEA has an advantage in that special case.)

 

[Galli]

Could it imply that his tax bill is lower than if the income from the investment was taxed? That’s how I interrupted it

 

[Audacious]

A is right.
cpk123 talks about “reducing the initial investment”; in this context he’s right. But the question talks about reduction of “the current tax bill”.
In TEA, you multiply the term by (1-T0). T0 is tax rate now
In TDA, you multiply the term by (1-Tn). Tn is tax rate at withdrawal.
If T0=Tn; no difference
If T0>Tn; TDA is preferred (less tax bill)
if T0<Tn; TEA is preferred