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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:. Should taxes matter in asset allocation?

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Taxes and Private Wealth Management: After-tax Asset Allocation

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  1. 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

  2. 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?

  3. Should taxes matter in asset allocation?

  4. 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.

  5. 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.

  6. 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.

  7. 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

  8. How do we calculate an after-tax asset allocation?

  9. 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.

  10. 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.

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

  12. 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)+.15 Exempt Investor: (1+r)n r=pretax return, n = investment horizon in years For simplicity assume all stock returns are capital gains

  13. Principal Owned, Returns Received, and Risk Borne by Individual Investors in Roth IRA, TDA, and Taxable Account Principal Returns Risk Roth IRA, bonds and stocks 100% 100% 100% TDA, bonds and stocks 72% 100% 100% Taxable Account bonds 100% 72% 72% stocks, day trader 100% 72% 72% stocks, active investor 100% 85% 85% stocks, passive investor 100% >85% >85% stocks, exempt investor 100% 100% 100% TDA denotes tax-deferred account such as 401(k)

  14. 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

  15. 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

  16. How should taxes affect asset location? Asset Location: Should bonds be held in retirement accounts and stocks in taxable accounts or vice versa?

  17. Tax-Oblivious Traditional Optimization: Jan’s Portfolio Pretax Pretax Portfolio Expected Standard Weights Returns 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

  18. Jan’s Portfolio: Tax Oblivious Market Savings Value Vehicle Stocks $500,000 TDA Bonds $500,000 Taxable 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

  19. 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

  20. Jan’s Portfolio: Tax Aware After-Tax Market Savings Value Value Vehicle Bonds$360,000 $500,000 TDA Stocks $500,000 $500,000 Taxable acct Total $860,000 After-tax Allocation: 58% stocks Asset Location: stocks in taxable accounts

  21. 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

  22. Logic of Asset Location

  23. 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.

  24. 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.

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