After-Tax Asset Allocation

Abstract

Several studies have found fundamental flaws in the traditional approach to managing individual investors’ portfolios, including a failure to distinguish between $1 of pretax funds in a 401(k) and $1 of after-tax funds in either a taxable account or Roth IRA. This study recommends that an individual’s asset values be converted to after-tax values and the asset allocation be based on the after-tax values. In general, within the target asset allocation, individuals should hold bonds and other assets subject to ordinary income tax rates in retirement accounts and hold stocks, especially passively managed stocks, in taxable accounts.

Several studies have concluded that we have been mismanaging individual investors’ asset allocations in two ways. In this article, I describe one of these errors—namely, the failure to calculate an individual’s asset allocation on an after-tax basis. The traditional approach to calculating asset allocation fails to distinguish between $1 of pretax funds in a 401(k) and $1 of after-tax funds in a taxable account or Roth IRA. Yet, if withdrawn in retirement today by someone in the 33 percent tax bracket, the $1 in the 401(k) will buy $0.67 of goods and services whereas the $1 in the taxable account or Roth IRA will buy $1 of goods and services.

This study advocates the calculation of after-tax asset allocation. To calculate an individual’s after-tax asset allocation, we must first convert all asset values to after-tax values. From my experience, the major adjustment that must be made with this approach is the conversion of pretax funds in 401(k) and other tax-deferred accounts. To convert these pretax funds to after-tax funds, one multiplies the pretax value by (1 –t_r), where t_r is the expected tax rate during retirement. Another issue is that assets in taxable accounts may have embedded but unrealized capital gains or losses. In those cases, it may be appropriate to reduce an asset’s market value to account for the embedded tax liability or increase the market value to account for the tax saving from the embedded tax loss. The “best” way to handle this issue depends on when, if ever, the gain or loss will affect the taxes to be paid.

Other investment implications flow from the after-tax framework. This framework changes the determination of an individual’s optimal asset allocation and asset location, where asset location refers to the decision to locate primarily bonds in retirement accounts and stocks in taxable accounts, or vice versa, while the target asset allocation is retained. Until recently, scholars recommended that these decisions be made sequentially by first determining optimal asset allocation, then optimal asset location. Today, we recognize that these decisions must be made jointly. In general, bonds and other assets whose returns are taxed at ordinary income tax rates should be held in retirement accounts whereas stocks, especially passively managed stocks, should be held in taxable accounts.

Financial advisors who use the traditional approach to calculate individuals’ asset allocations are miscalculating their true allocations. This approach fails to distinguish pretax funds from after-tax funds. Furthermore, the measurement errors can be substantial. This study advocates the calculation of an individual’s after-tax asset allocation so that after-tax funds are compared with after-tax funds. Thus, the approach corrects a major deficiency in the traditional approach.

Notes

¹ Reichenstein (1998, 2000, 2001b);Reichenstein and Jennings (2003);Jennings and Reichenstein (2004);Dammon, Spatt, and Zhang (2004).

² For more discussion of this second issue, see Reichenstein (1998, 2000, 2001b), Reichenstein and Jennings (2003), and Jennings and Reichenstein (2004).