Two Key Concepts for Wealth Management and Beyond (corrected March 2012)

Abstract

Asset allocation is profoundly influenced by at least two underappreciated concepts. First, tax-deferred accounts—for example, 401(k)s—are like partnerships in which the investor owns (1 – t_n) of the partnership principal and the government owns the remainder, where t_n is the marginal tax rate when the funds are withdrawn. Second, the government shares in both the return and the risk of assets held in taxable accounts. The authors discuss these concepts’ implications for wealth management.

In this study, we presented two key concepts and discussed some of their investment implications. The first concept is that a tax-deferred account (TDA), such as a 401(k), is like a partnership in which the investor owns (1 – t_n) of the partnership principal and the government owns the remaining t_n of principal, where t_n is the marginal tax rate when the funds are withdrawn. The second concept is that the government shares in both the return and risk of assets held in taxable accounts, unlike funds in TDAs or tax-exempt accounts (e.g., Roth IRAs). These concepts have important implications for several areas in wealth management.

• The after-tax value of funds in a tax-deferred account grows tax exempt.

• The calculation of an individual’s or a couple’s asset allocation should be based on after-tax balances in each savings vehicle. In contrast, the traditional approach fails to distinguish between pretax and after-tax dollars.

• When calculating an individual’s or a couple’s asset allocation, pretax balances in TDAs should be converted to after-tax dollars by multiplying the pretax balances by (1 – t_n).

• There is an optimal asset location, which is inextricably linked to portfolio optimization. Individuals should locate lightly taxed securities in taxable accounts and heavily taxed securities in tax-advantaged retirement accounts to the highest degree possible, while maintaining their risk–return preference.

• The main factor in the decision to save in a tax-deferred account or a tax-exempt account is a comparison of the marginal tax rates in the deposit year and in the withdrawal year. In general, if the expected marginal tax rate in retirement is lower than this year’s tax rate, then the individual should save in a TDA, and vice versa.

• Similarly, the most important factor in a Roth conversion decision is the comparison of the marginal tax rates in the conversion year and in the withdrawal year in retirement. If this year’s marginal tax rate is lower than the withdrawal tax rate, it pays to convert funds to a Roth account this year. The optimal conversion amount would push an investor to the top of the tax bracket just below his or her estimated marginal tax rate in retirement. To convert all of an individual’s pretax TDAs to after-tax dollars in the same year is seldom appropriate.

• Suppose a U.S. retiree faces a 25 percent marginal tax rate. To make the portfolio last as long as possible, he or she generally should withdraw funds from taxable accounts before TDAs or tax-exempt accounts. This rule has exceptions, however, most of which are based on our first key concept.

• For estate tax planning, choosing whether to gift or bequeath assets is analogous to choosing between a traditional IRA and a Roth IRA—that is, a comparison of the tax rates today and those expected in the future is the critical factor.

The opinions expressed are those of the authors and not necessarily those of the United States Air Force Academy, the United States Air Force, or any other federal agency.

Notes

¹ See, for example, Dammon, Spatt, and Zhang (2004); Horan (2005, 2007a, 2007b); Reichenstein (2001, 2006a, 2006b, 2007a, 2007b); Reichenstein and Jennings (2003).

² Bernheim, Skinner, and Weinberg (1997) showed that, on average, retirement income is about 64 percent of preretirement income, which suggests that marginal tax rates for many retirees will fall.

³ We assumed that the long-term capital gains rate would rise to 20 percent. The key is that dividends and/or long-term gains will be taxed at rates below the ordinary income tax rate.

⁴ Reichenstein (2008) noted one exception to this location preference: To serve their purpose, liquidity reserves must be held in taxable accounts.

⁵ Depending on how the stock returns are divided between dividends and capital gains and how long gains are allowed to grow before being realized, the effective tax rate on stocks may be lower or higher than 20 percent. So long as some stock returns are taxed at the favorable long-term gains tax rate, the effective tax rate on stocks is less than the effective tax rate on bonds when held in taxable accounts and the optimal location is to hold stocks in taxable accounts and bonds in retirement accounts to the greatest degree possible, while maintaining the investor’s risk–return preference. Dammon, Spatt, and Zhang (2004) showed that if the tax drag on an equity strategy is high enough, it may be beneficial to locate equity in the TDA and place municipal bonds in the taxable account, but the necessary conditions are somewhat extreme.

⁶ For more on the mechanics, details, and implementation issues of after-tax portfolio optimization, see Dammon, Spatt, and Zhang (2004); Horan (2005, 2007a, 2007b); Horan and Al Zaman (2008); Reichenstein (2001, 2007a, 2007b, 2008); Reichenstein and Jennings (2003); Wilcox, Horvitz, and diBartolomeo (2006).

⁷ In this example, we assume that taxes are paid from the converted funds and that there is no penalty tax associated with this distribution because the individual is younger than age 59.5. When possible, taxes should be paid from separate taxable funds. Horan (2005) provided an analysis based on the assumption that taxes are paid from funds in the traditional IRA, which significantly reduces any tax motivation for converting assets.

⁸ The “in general” qualification is due to the so-called tax torpedo. There is a range in which each additional dollar of TDA funds that is converted to a tax-exempt account causes taxable income to rise by either $1.50 or $1.85 because it causes an extra $0.50 or $0.85 of Social Security benefits to be taxed. For these investors, the marginal tax rate is 50–85 percent higher than the tax bracket for the income range. The tax torpedo primarily affects low- and moderate-income taxpayers. We do not address the tax torpedo in this article.

⁹ See “Withdrawal Sequence: Couple, Age 62 with $1,500,000 of Assets” at www.retireeincome.com/resources/learning_library.html.