Taxes and private wealth management after tax asset allocation
This presentation is the property of its rightful owner.
Sponsored Links
1 / 24

Taxes and Private Wealth Management: After-tax Asset Allocation PowerPoint PPT Presentation


  • 86 Views
  • Uploaded on
  • Presentation posted in: General

Taxes and Private Wealth Management: After-tax Asset Allocation. Texas Investment Portfolio Symposium. March 24, 2007 William Reichenstein, PhD, CFA Tom Powers Professor of Investments Baylor University. Outline:. Should taxes matter in asset allocation?

Download Presentation

Taxes and Private Wealth Management: After-tax Asset Allocation

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Taxes and private wealth management after tax asset allocation

Taxes and Private Wealth Management: After-tax Asset Allocation

Texas Investment Portfolio Symposium

March 24, 2007

William Reichenstein, PhD, CFA

Tom Powers Professor of Investments

Baylor University


Outline

Outline:

  • Should taxes matter in asset allocation?

  • How do we calculate an after-tax asset allocation?

  • How does the choice of savings vehicles affect the portion of principal effectively owned by, return received by, and risk borne by individual investors?

  • How should taxes affect asset location?


Should taxes matter in asset allocation

Should taxes matter in asset allocation?


Assumptions

Assumptions

For simplicity, let’s assume the ordinary income tax bracket during retirement is 28%, tn = 0.28,

--Ordinary income tax bracket before retirement is 28%, t = 0.28, and

--Capital gain tax bracket before and during retirement, tc = 0.15.


Tda versus roth ira

TDA versus Roth IRA

  • Joe has $100 of pretax funds in a tax-deferred account (TDA) and $72 of after-tax funds in a Roth IRA invested in the same asset.

  • They will buy the same amount of goods and services in retirement.

  • The $100 of pretax funds in TDA can be separated into $72 of after-tax funds plus $28, the government’s share of the currentprincipal.

  • TDAs include 401(k), 403(b), traditional IRA, Keogh, etc.


What is the asset allocation

What is the Asset Allocation?

  • $100K in stocks held in TDA and

    $72K in bonds held in Roth IRA

  • What is Joe’s asset allocation?

  • According to the traditional approach to calculating an asset allocation, it is 58% stocks and 42% bonds.

  • According to the after-tax approach, it is 50% stocks and 50% bonds.


Taxes and private wealth management after tax asset allocation

Lessons

The traditional approach is wrong, because it considers the TDA to be worth 39% more than the Roth IRA.

By failing to distinguish between pretax funds and after-tax funds, the traditional approach mixes apples and oranges.

You can convert pretax dollars in TDAs to after-tax dollars by multiplying by (1 – tn), where tn is the tax rate at withdrawal in retirement


How do we calculate an after tax asset allocation

How do we calculate an after-tax asset allocation?


What is jan s asset allocation

What is Jan’s Asset Allocation?

  • $500,000 Stocks held in TDA

  • $500,000 Bonds held in taxable account

  • For simplicity, assume cost bases equal market values of assets held in taxable accounts.

  • See Reichenstein (2006) and references therein for treatment of unrealized gains and losses.


What is jan s asset allocation1

What is Jan’s Asset Allocation?

--According to the traditional approach, she has a 50% stocks-50% bonds allocation.

--According to after-tax asset allocation, she has $360,000 after taxes in stocks and $500,000 in bonds for a 42% stocks-58% bonds allocation.

--The traditional approach exaggerates the allocation to the dominant asset held in tax-deferred accounts.


Taxes and private wealth management after tax asset allocation

How does the choice of savings vehicles affect the portion of principal effectively owned by, return received by, and risk borne by individual investors?


After tax ending wealth models for bonds and stocks in roth ira tda and taxable account

After-tax Ending Wealth Models for Bonds and Stocks in Roth IRA, TDA, and Taxable Account

Beginning investment value: $1

Bonds Stocks

Roth IRA (1+r)n (1+r)n

TDA e.g.,(401(k)(1+r)n (1-.28) (1+r)n (1-.28)

Taxable Account (1+r(1-.28))n Day Trader: (1+r(1-.28))n

Active Investor: (1+r(1-.15))n

Passive Investor: (1+r)n(1-.15)+.15Exempt Investor: (1+r)n

r=pretax return, n = investment horizon in years

For simplicity assume all stock returns are capital gains


Taxes and private wealth management after tax asset allocation

Principal Owned, Returns Received, and Risk Borne by Individual Investors in Roth IRA, TDA, and Taxable Account

Principal ReturnsRisk

Roth IRA, bonds and stocks100%100%100%

TDA, bonds and stocks 72%100% 100%

Taxable Account

bonds 100%72%72%

stocks, day trader100%72%72%

stocks, active investor100%85%85%

stocks, passive investor100%>85%>85%

stocks, exempt investor 100%100%100%

TDA denotes tax-deferred account such as 401(k)


Risk sharing for active stock investor

Risk Sharing for Active Stock Investor

  • Suppose pretax returns are -8%, 8%, and 24% in three years. Mean = 8%, standard deviation = 16%

  • After-tax returns: -6.8%, 6.8%, and 20.4%. Mean = 6.8% or 8%(1-.15) standard deviation = 13.6% or 16%(1-.15)

  • The individual receives 85% of returns and bears 85% of risk


Risk sharing for bond investor

Risk Sharing for Bond Investor

  • Suppose pretax returns are -5%, 5%, and 15% in three years. Mean = 5%, standard deviation = 10%

  • After-tax returns: -3.6%, 3.6%, and 10.8%. Mean = 3.6% or 5%(1-.28) standard deviation = 7.2% or 10%(1-.28)

  • The individual receives 72% of returns and bears 72% of risk


Taxes and private wealth management after tax asset allocation

How should taxes affect asset location?

Asset Location: Should bonds be held in retirement accounts and stocks in taxable accounts or vice versa?


Tax oblivious traditional optimization jan s portfolio

Tax-Oblivious Traditional Optimization: Jan’s Portfolio

PretaxPretax

PortfolioExpectedStandard

WeightsReturns Deviation

Stocks 50%8%16%

Bonds 50% 5%10%

Maximize Utility = E(return)-StDev/RiskTol = .0650 - .1024/2.53 = .0245

Constraints: S ≥ 0, B ≥ 0, S + B = 1.0

Correlation between stocks and bonds = 0.2


Jan s portfolio tax oblivious

Jan’s Portfolio: Tax Oblivious

Market Savings

ValueVehicle

Stocks$500,000TDA

Bonds$500,000Taxable acct

Total $1,000,000

Stock Allocation: traditional 50% (after-tax 42%)

Asset Location: silent; assumed stocks in TDA

Most people have primarily stocks in retirement accounts


Tax aware optimization

Tax-Aware Optimization

Portfolio Expected Standard

Weights Returns Deviation

Stocks TDA 0% 8%16%

Bonds TDA 42% 5%10%

Stocks Taxable 58%6.8% 13.6%

Bonds Taxable 0% 3.6% 7.2%

Active stock investor

Maximize Utility = E(return)-Stdev/RiskTol = .0604 - .0965/2.53 = .0223

Constraints: S(TDA), B(TDA), S(t), B(t) ≥ 0,

S(TDA) + B(TDA) = 0.42,

S(TDA) + B(TDA) + S(t) + B(t) = 1


Jan s portfolio tax aware

Jan’s Portfolio: Tax Aware

After-Tax Market Savings

Value ValueVehicle

Bonds$360,000$500,000TDA

Stocks$500,000$500,000Taxable acct

Total $860,000

After-tax Allocation: 58% stocks

Asset Location: stocks in taxable accounts


Other target asset allocations

Other Target Asset Allocations

After-Tax Values

50% Stocks 70% Stocks

Bonds TDA$360,000 $258,000

Stocks TDA $0$102,000

Bonds Tax Acct $70,000 $0

Stocks Tax Acct$430,000$500,000

Total $860,000$860,000

  • Bonds and stocks should not be held in both retirement and taxable accounts …

  • … except liquidity reserves must be in taxable acct


Logic of asset location

Logic of Asset Location


Generalized advice on asset location

Generalized Advice on Asset Location

  • Place bonds, REITs, hedge funds and other assets with returns subject to ordinary income tax rate in TDAs and Roth IRAs.

  • Place stocks, especially passively held stocks, in taxable accounts.


References

References

  • Reichenstein & Jennings, Integrating Investments and the Tax Code, Wiley, 2003.

  • Reichenstein, “After-tax Asset Allocation,” Financial Analysts Journal, July/August, 2006.

  • Reichenstein, “Tax-Efficient Saving and Investing,” www.tiaa-crefinstitute.org/research/trends/tr020106b.html

  • Waltenberger et al, “The Expanding Roth IRA,” www.tiaa-crefinstitute.org/research/trends/tr030106.html

  • Reichenstein, “Tax-Efficient Sequencing of Accounts to Tap in Retirement,” See www.tiaa-crefinstitute.org/research/trends/tr100106.html

  • Jennings & Reichenstein, “The Literature of Private Wealth Management,” Research Foundation of CFA Institute, forthcoming.


  • Login