The 3 Key Tax Principles for the CFA Exam

The first thing you should know about the tax section on the CFA level 3 exam is that there are three key lessons the test takers want to drive home about taxes and investment returns. Most questions will test your ability to apply these principles, plus they can help you eliminate options on multiple choice questions. Let's go over each. 

Lesson 1: The less you trade the more tax efficient your portfolio is

This is because:

  1. Capital gains are usually taxed at a lower rate than income
  2. Long-term capital gains usually have lower rates than short term capital gains.

Thus passive long-term strategies pay less in taxes than active trading strategies.

That means the more active your investment strategy the higher the expected return needs to be in order to their higher tax rates. On Level 3 especially, the idea of needing better performance to overcome increased costs is a key concept that shows up over and over.

As a side note, the reason a government would design their tax policies to favor long term holdings is to encourage saving and investment and enhance GDP growth. This ties into the CFA curriculum material around tax regimes. [1] 

Lesson 2: The longer you can defer paying taxes the more your overall portfolio will benefit

The longer you defer taxes the more time you can compound returns tax free and the better your overall performance will be.

The basic idea Lesson number two should be fairly intuitive: When you don't pay taxes today that money can get reinvested and will itself compound. This is straightforward time value of money stuff in that the longer you push out the tax horizon, the more the money will compound and the more your portfolio will benefit.

This idea is certainly tested and articulated in the tax equations that you'll see in the level 3 tax section. Here each equation relates to a different tax regime that either makes you pay taxes annually or at the end of a given period etc. You should recognize which strategy will lead to higher returns based on when you pay taxes without having to plug values into equations.

Lesson 3: Relative tax rates matter

In an estate planning context especially, the timing of transferring an estate depends on the tax rates and structures of the giver and receiver. This also applies when comparing whether to hold assets within a tax exempt or tax deferred retirement account. Ultimately you should be able to determine which account ends up being more valuable based on their relative tax treatment.

Take the relative tax rates between a benefactor and an inheritor. If the benefactor pays higher taxes than the receiver, it makes more sense to give the gift now so it can be taxed at lower rates as it grows. The logic is similar between different types of retirement accounts, and we'll look at the math in comparing a tax-exempt and tax-deferred account in a separate post. mathematical problems when you're comparing a tax-exempt and a tax-deferred account. On the Level 3 exam expect this concept to be tested directly with a multiple choice question or two where you will need to be able to determine which account is more valuable based on the relative tax treatment.


[1] From the government’s perspective this is to encourage saving and investment (and hence GDP growth). The overall sentiment here should make some sense to you by now. The CFA institute teaches/believes in Modern Portfolio Theory (MPT) and the idea of long-term asset allocation in light of rational markets is a key one for them.