Taxes and Private Wealth Management: After-tax Asset Allocation

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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

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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?

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• Should taxes matter in asset allocation?

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Assumptions

• For simplicity, lets 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.

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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
  governments share of the current principal.
• TDAs include 401(k), 403(b), traditional IRA,
  Keogh, etc.

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What is the Asset Allocation?

• 100K in stocks held in TDA and
• 72K in bonds held in Roth IRA
• What is Joes 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.

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The traditional approach is wrong, because it
considers the TDA to be worth 39 more than the
Roth IRA.
Lessons

• 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

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• How do we calculate an after-tax asset
  allocation?

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What is Jans 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.

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What is Jans 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.

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

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After-tax Ending Wealth Models for Bonds and
Stocks in Roth IRA, TDA, and Taxable Account
Beginning investment value 1 Bonds
Stocks Roth IRA (1r)n (1r)n TDA
e.g.,(401(k) (1r)n (1-.28) (1r)n (1-.28)
Taxable Account (1r(1-.28))n Day
Trader (1r(1-.28))n Active Investor
(1r(1-.15))n Passive Investor
(1r)n(1-.15).15 Exempt Investor (1r)n
rpretax return, n investment horizon in
years For simplicity assume all stock returns are
capital gains
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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 gt85 gt85 stocks, exempt
investor 100 100 100 TDA denotes
tax-deferred account such as 401(k)
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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

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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

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

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Tax-Oblivious Traditional Optimization Jans
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

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Jans 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

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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

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Jans 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

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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

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Logic of Asset Location
Stock management style
Asset Location Active Investor
Stocks in taxable accounts Bonds in TDA (or Roth IRA) 15 tax rate Tax exempt
Bonds in taxable accounts Stocks in TDA (or Roth IRA) 28 tax rate Tax exempt
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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.

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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/tr
  ends/tr020106b.html
• Waltenberger et al, The Expanding Roth IRA,
  www.tiaa-crefinstitute.org/research/trends/tr03010
  6.html
• Reichenstein, Tax-Efficient Sequencing of
  Accounts to Tap in Retirement, See
  www.tiaa-crefinstitute.org/research/trends/tr10010
  6.html
• Jennings Reichenstein, The Literature of
  Private Wealth Management, Research Foundation
  of CFA Institute, forthcoming.