Picking between tax deferred (TDA) and tax exempt accounts (TEA)
This is a round-up of somewhat random but highly testable CFA level 3 tax material including tax loss harvesting, HIFO accounting, and when to use a TDA vs. TEA account.
Why Taxes influence where you hold your money
When thinking about asset allocation, it isn’t just how you diversify across assets that matters. It also matters where you hold certain assets. Clearly you want to hold assets in the accounts that provide the most favorable tax treatment.
A mean-variance efficient portfolio can look very different after all the tax implications of different investments are considered. And when a manager is looking at asset allocation they should always be considering after-tax returns and after-tax risk when making decisions, not pre-tax returns. Note, the process of adding value to a portfolio via tax management is called tax alpha.
Taxes & Risk
While taxes reduce investment returns they also reduce investment risk if taxed annually. This is because the government now has a claim on part of your returns. Think of it as the government getting a stake in your portfolio and becoming your investing partner. The risk you are actually taking on is no longer the full standard deviation of returns, it is now Std Dev * (1-tax rate).
Note, however, that in retirement accounts (both TDA and TEA) you still bear all of the risk as the government is not bearing any of the annual volatility risk. They just take their cut at the end.
Taxes & Investment Behavior
- Hold heavily taxed assets in a tax-advantaged account
- Hold lightly taxed assets in a taxable account
- Note: If you have unrealized losses you’d rather have that in a taxable account so you can offset other gains via tax loss harvesting
Tax Deferred vs. Tax-Exempt Accounts
Testing in this section is usually about comparing which of the types of accounts will result in higher investment return in the future. Before we get into that lets define the two types of accounts.
Tax-deferred accounts are accounts where we contribute with pre-tax dollars and then pay taxes at the end at whatever our applicable tax rate is at that point in time. Tax-exempt accounts kind of work in the opposite way: we contribute after-tax dollars but then anything that's in the account compounds tax-free.
How do you pick which account to put money into?
First, you have to compare today's tax rates versus future rates. If you think that tax rates are going to be higher in the future, you want to invest in a tax-exempt account. That's because you'll be taxed today at the lower rate, but then your returns will compound tax-free. The opposite is true if you think rates will be lower in the future: you want to invest in a tax-deferred account with pre-tax dollars and pay the taxes at the end.
One way that this gets complicated on the CFA Level 3 exam is that there are also regulatory limits to the dollar contributions. If you see that, you should know that if the tax rates are the same AND the dollar contribution limit is the same, a tax-exempt account will be superior to the tax deferred account.
 Remember that volatility is a proxy to measure risk.