Most types of investment accounts can be classified into three categories.
The first type is taxable accounts. Investments to these accounts are made on an after-tax basis and returns can be taxed in a variety of ways as discussed in the previous section.
A second class of accounts can be called tax-deferred accounts, or TDAs. Contributions to these accounts may be made on a pretax basis, and the investment returns accumulate on a tax-deferred basis until funds are withdrawn at which time they are taxed at ordinary rates. As such, these accounts are sometimes said to have front-end loaded tax benefits. In Canada they are called Registered Retirement Savings Plans, and in the United States some are called Individual Retirement Accounts.
A third class of accounts has back-end loaded tax benefits. These accounts can be called tax-exempt because although contributions are not deductible, earnings accumulate free of taxation even as funds are withdrawn, typically subject to some conditions. An example is the Roth IRA in the United States.
Assets held in a TDA accumulate on a tax deferred basis. Tax is owed when funds are withdrawn at the end of an investment horizon at which time withdrawals are taxed at ordinary rates or another rate, Tn, prevailing at the end of the investment horizon. The future after-tax accumulation of a contribution to a TDA is therefore equal to:
- FVIFTDA = (1 + r)n(1 – Tn)
Assets in a TDA have a built-in tax liability whereas assets in a tax-exempt account do not. It can be shown that the value of an asset held in a TDA measured on an after-tax basis is therefore equal to (1 − Tn) times the value of the same asset held in a tax-exempt account. The taxing authority essentially owns Tn of the principal value of a TDA, regardless of the type of asset held in it, leaving the investor effectively owning only (1 − Tn) of the principal.
Tax-exempt accounts have no future tax liabilities. Earnings accumulate without tax consequence and withdrawals create no taxable event. Therefore, the future accumulation of a tax-exempt account is:
- FVIFTaxEx = (1 + r)n
After-Tax Asset Allocation
The notion that a TDA is worth (1 − Tn) times an otherwise equivalent tax-exempt account has implications for after-tax asset allocation, which is the distribution of asset classes in a portfolio measured on an after-tax basis.
Therefore, estimating an investor’s time horizon presents a potential impediment to incorporating after-tax asset allocation in portfolio management. Another challenge is improving client awareness, understanding, and comfort with asset allocation from an after-tax perspective.