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?
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
Should taxes matter in asset allocation?
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.
$72K in bonds held in Roth IRA
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?
--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.
How does the choice of savings vehicles affect the portion of principal effectively owned by, return received by, and risk borne by individual investors?
Beginning investment value: $1
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
Roth IRA, bonds and stocks100%100%100%
TDA, bonds and stocks 72%100% 100%
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)
How should taxes affect asset location?
Asset Location: Should bonds be held in retirement accounts and stocks in taxable accounts or vice versa?
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
Stock Allocation: traditional 50% (after-tax 42%)
Asset Location: silent; assumed stocks in TDA
Most people have primarily stocks in retirement accounts
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
After-Tax Market Savings
After-tax Allocation: 58% stocks
Asset Location: stocks in taxable accounts
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