How to Calculate an After-Tax Asset Allocation

Reichenstein, William
August 2008
Journal of Financial Planning;Aug2008, Vol. 21 Issue 8, p62
Academic Journal
• In a previous article published in the Journal of Financial Planning, the author argued for the importance of converting all assets' market values to after-tax values when calculating an individual's asset allocation. This approach provides a more accurate measure of his or her asset allocation. By adjusting for taxes, we also get a more accurate estimate of after-tax portfolio returns. The traditional asset allocation approach ignores taxes and thus implicitly assumes taxes do not exist. The differences in asset allocation calculations between these two methods is not minor. • But calculating asset allocation on an after-tax basis is more complex than the traditional approach. This article, adapted from the author's newly released book from FPA Press, goes into more detail to show the practitioner how to convert assets to an after-tax basis by adjusting market values for embedded tax liabilities. • Usually the adjustment for the embedded tax liability in tax-deferred accounts has the greatest impact on the after-tax asset allocation calculation. The challenge is in estimating the expected marginal tax rate when funds are withdrawn in retirement. • The article also shows the impact and challenges of determining embedded tax liabilities in taxable accounts and nonqualified annuities. For example, in the case of taxable stock investments, the calculation will depend in part on whether the investor is an active or passive trader, or perhaps intends to donate the stock to charity. • The article provides several examples illustrating the application of the after-tax approach. An appendix explains how the current after-tax value of an asset should equal its after-tax future value when discounted back to the present at a risk-appropriate discount rate.


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