Calculating After-Tax Asset Allocation Is Key to Determining Risk, Returns, and Asset Location

Reichenstein, William
July 2007
Journal of Financial Planning;Jul2007, Vol. 20 Issue 7, p44
Academic Journal
• This study presents a unified flamework that addresses the differences in risk and returns on taxable and retirement accounts. • It explains the logic of calculating an individual's after-tax asset allocation, where we first convert all account values to after-tax funds and then calculate the asset allocation based on these values. For example, we must first convert the pretax funds in tax deferred accounts, such as a 401 (k), into after-tax funds before calculating the after-tax asset allocation. • The study examines how the choice of savings vehicles, such as a Roth IRA, tax-deferred account, or taxable account, affects the portions of principal effectively owned by, return received by, and risk borne by the individual investor. • A dollar in a tax-deferred account is like (l - tn) dollar in a Roth IRA, where tn, is the expected tax rate in retirement. The investor effectively owns (l - tn) of the current principal, but receives all of an asset's returns and bears all of an asset's risk. • This study explains how an investor's stock management strategy affects the after-tax risk and returns on stocks held in taxable accounts. • It demonstrates that, in a mean-variance optimization, a bond held in a retirement account is effectively a different asset than a bond held in a taxable account. The same statement usually applies to stocks. • The study also examines the implications of this unified framework for- the asset location decision. Except for extreme cases, individuals should locate bonds in retirement accounts and stocks--especially passively managed stocks--in taxable accounts, while attaining their target asset allocation.


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