Summarizing the Testable Tax Material for CFA Level 3
Remember that level 3 is all about managing a portfolio in the real world. The fact that it's more practical (think behavioral vs. traditional finance) means we care most about after tax returns.
And that, by default, means we need to know how to deal with taxes.
What you need to know about taxes for CFA L3
Consider this post and the links it points to your review of all the testable L3 material surrounding taxes.
3 Guiding Tax Principles to start with
- The less you trade, the more tax efficient your portfolio will be
- The longer you defer paying taxes the faster your portfolio will compound
- Relative tax rates matter
From there, know that taxes are levied under different tax regimes
After reading more about why these three principles can guide you, it's time to understand the 3 main tax systems - income, wealth, and consumption/VAT. Key testable material here includes the 7 regimes (progressive etc) and how they treat dividends, income, and capital gains. Our post breaks all of it down for you.
FVIF and Calculations
After a quick refresher on the difference between marginal and average tax rates it's time to dive into the heart of the tax calculation section. Candidates get bogged down here in the mix of equations but it's not as bad as it looks.
Read the full post on tax equations and tax drag to learn what you need in order to solve questions around:
- Specific return calculations under a given scenario (i.e. using one of the FVIF equations)
- How the amount of return and length of time influence tax drag (on both a percentage or dollar basis) depending on the timing of the tax
- How government taxes impact investment risk
Once you've got individual calculations down, it's worth spending a bit of time with blended tax equations and calculating the effective capital gains tax. The 3-4 possible calculations run through here could be worth a point or two in the afternoon.
International Tax Complications and Tax Jurisdictions
International tax issues are actually addressed in a standalone section inside of estate planning. The basic concept is that an individual can be taxed based on where they live and work (Source), where they are from (residence), or both.
For the L3 exam you should be able to calculate how these disputes would be settled using the credit, exemption, and/or deduction methods. We dive into that in this post.
Investment Risk, Tax Loss Harvesting, and HIFO
The tax readings end with three testable discussions.
The first is choosing between tax exempt and tax deferred accounts.
The second deals with the fact that when the government takes out annual taxes, they also decrease your overall investment risk. Think of them as an unwelcome trading partner that gets part of your upside.
The third, and least important of the three miscellaneous subjects, talks about tax loss harvesting and highest in, first out accounting (HIFO).
Tax loss harvesting essentially uses investment losses in any one position to offset investment gains in another. This leads to overall savings because you're reducing the taxable principal by the amount of that loss. In the real world, you see this with most investors selling stocks that have declined over the course of the year in the fourth quarter and then selling any of their winners in Q1. It’s a simple time value of money benefit question, even if total taxes remain the same in the end.
Highest in, First Out Accounting is related in the sense that it's a TVM arbitrage strategy. Basically, it takes this concept that you might be building a position in a stock over time and doing so at different prices. So when you sell the stock, if it's allowed, you can claim that, “I've sold the highest cost basis stock that I have acquired first.” Then any subsequent sale of stock goes down in descending order.
With HIFO your total taxes are going to be unchanged. But as with tax loss harvesting what matters is when you pay the taxes. The one caveat here is that if you think tax rates are going to go up in the future, you might actually want to sell the lower cost basis stock first and take the tax hit now before the rates go up.
Hopefully this gives you a firm grasp of where and how taxes get tested on L3. Outside of what we've covered remember to factor them in on IPS return calculations as needed.