Taxable Account Research Articles

Tax-Aware Investing

This study has three major sections. The first section examines how management style affects the share of returns received by and risk borne by the investor when stocks are held in a taxable account. One good management strategy is to manage stocks passively, ideally until the capital gains qualify for a step-up in basis at death or are used to fund a charitable contribution. The second examines the optimal location of assets in a portfolio comprising both taxable and tax-exempt pockets. It concludes that, to the degree possible without violating the target asset allocation, stocks should be passively held in taxable accounts and bonds should be held in retirement accounts. The third section examines dynamic tax-aware investing. Predictably, a good approximation to optimal behavior for a tax-aware investor is to realize all losses and let capital gains grow unrealized.

Strategies for Maximizing Estate Wealth

The conventional wisdom that using tax-sheltered accounts such as Keogh plans, IRAs, 401(k) programs, etc. is an excellent way to save for retirement but a poor way to accumulate an estate is shown to be incorrect at least under a variety of reasonable circumstances. It is shown that net estate wealth (i.e., after income and estate taxes) generally will be greater by saving in such plans compared to saving in conventional (i.e., taxable) accounts. The misconception arises because the net wealth left after taxes on two estates of equal size at death will be less when a significant part of the assets are in tax-sheltered plans, but this is not a fair comparison because if all other factors (e.g., income and consumption during the accumulation period, pre-tax rates of return, etc.) are held constant, the estate associated with the tax-sheltered investment will unequivocally be larger at the time of death. It is also shown that saving in tax-sheltered plans during the early years of the lifecycle, followed by saving in a taxable account in the later years, will generate a maximum after-tax transfer to heirs.

Evaluating and Classifying Taxable Account Managers

University and professional certification programs provide excellent course offerings designed to serve the traditional market for endowment, foundation, and retirement plan investing. However, the impact of taxes is all too often completely ignored. Fortunately, there is a body of truly passionate practitioners that are making significant contributions to further the understanding of taxable account investing. Their work is emerging primarily through articles in professional journals and presentations at wealth management conferences. The purpose of this article is to provide detailed insight into the evaluation and classification of taxable account investment managers. To gauge a manager9s ability, or lack thereof, to create alpha on an after-tax basis, knowledge of both the “science” and “art” of tax-aware investing is essential. The “science” involves calculating, analyzing, and interpreting after-tax return performance information, while the “art” consists of a subjective analysis of the tax management tools and techniques utilized by investment managers.

Valuing Assets in Retirement Saving Accounts

This paper compares the value of one dollar of an asset held in a tax-deferred account with one dollar of a similar asset held in a taxable account from the standpoint of providing future retirement income. Taxes that are due when assets are withdrawn from some retirement saving plans can make a dollar held inside a retirement account less valuable than a dollar held in a similar asset outside these accounts, particularly for those who are considering withdrawing assets from the tax-deferred accounts in the near future. This effect is more than offset, however, particularly for younger workers, by the benefits of many years of asset growth at pre-tax rates of return. This paper calibrates the value of the tax burden, and the benefit of compound growth, for assets held in retirement accounts, and describes the differences in relative valuation for households of different ages.

Optimal Asset Location and Allocation with Taxable and Tax‐Deferred Investing

ABSTRACTWe investigate optimal intertemporal asset allocation and location decisions for investors making taxable and tax‐deferred investments. We show a strong preference for holding taxable bonds in the tax‐deferred account and equity in the taxable account, reflecting the higher tax burden on taxable bonds relative to equity. For most investors, the optimal asset location policy is robust to the introduction of tax‐exempt bonds and liquidity shocks. Numerical results illustrate optimal portfolio decisions as a function of age and tax‐deferred wealth. Interestingly, the proportion of total wealth allocated to equity is inversely related to the fraction of total wealth in tax‐deferred accounts.

Comment on ‘Household Portfolio Choices in Taxable and Tax-Deferred Accounts: Another Puzzle?’

Using an arbitrage approach, Black (1980) and Tepper (1981) conclude that the optimal corporate pension policy is for companies to fully fund their pension plans, borrowing on corporate account if necessary, and investing the pension fund entirely in taxable bonds. The implications of the Black-Tepper arbitrage results for optimal asset location for individual investors were first discussed in Dammon et al. (1999). They demonstrate in their numerical analysis that the investor should optimally hold taxable bonds in his tax-deferred account and stocks in his taxable account, borrowing if necessary to achieve the optimal overall risk exposure. When the investor faces a binding borrowing constraint, he may hold some stock in his tax-deferred account, but only if his taxable account is entirely invested in equity. This optimal asset location policy was later formally derived by both Huang (2000) and Dammon et al. (2004) using the Black-Tepper arbitrage approach. Studies by Shoven (1999), Shoven and Sialm (2002), and Poterba et al. (2000) provide an alternative view. They argue that because many actively managed mutual funds distribute a large fraction of capital gains each year it can be optimal to hold equity in the tax-deferred account and tax-exempt bonds in the taxable account. However, Dammon et al. (2004) demonstrate that holding equity in the taxdeferred account, and tax-exempt bonds in the taxable account, is optimal only if the form of equity holding is highly tax-inefficient and significantly outperforms a tax-efficient index fund. Given the well-documented evidence on the underperformance of actively managed mutual funds, Dammon et al. (2004) conclude that investors would be better off holding index funds (or individual stocks) in the taxable account and taxable bonds in the tax-deferred account.

Portfolio Decisions with Taxable and Tax-Deferred Accounts: A Tax-Arbitrage Approach

We analyze an intertemporal portfolio problem with both taxable and tax-deferred retirement accounts. Using a tax-arbitrage argument, we identify conditions under which the optimal location decision (of where to place an asset) is separable from the allocation decision (of how much to allocate to each asset). Investors place highly taxed assets in the tax-deferred account to maximize the tax benefit, and adjust their taxable portfolios to achieve the optimal risk exposure. We show that the two-account problem can be reduced to a taxable-account-only problem. The results are robust to the possibility of postponing capital gains taxes, consumption and contribution decisions, and stochastic tax rates.

Portfolio Allocation Choices in Taxable and Tax-Deferred Accounts: An Empirical Analysis of Tax-Efficiency

Tax efficiency is the dominant consideration in theoretical portfolio models that allow for both taxable and tax-deferred accounts. Yet, empirically observed portfolio allocations are not tax-efficient. I offer a model that is designed to bridge the existing gap and validate its predictions on household-level portfolio data from the Survey of Consumer Finances. The model explicitly incorporates both the uninsurable risk in labor income and accessibility restrictions that are an institutional feature of tax-deferred retirement accounts. Together, these elements create a tension between the desire to maintain tax-efficient allocations and one's concern over the need to make costly withdrawals from retirement accounts in the event of bad income draws. This leads some low-wealth households and households facing the highest penalties on withdrawals to forgo tax-efficient allocations in favor of allocations that provide more liquidity. The empirical results provide evidence that both the choice of a tax-inefficient portfolio and heterogeneity in portfolio allocations are related to the presence and severity of accessibility restrictions and precautionary motives.

Asset location in tax-deferred and conventional savings accounts

This paper derives optimal asset allocations (which assets to hold) and asset locations (in which accounts to hold them) for a risk-averse investor saving for retirement. The investor can hold taxable corporate bonds, tax-exempt municipal bonds, and stocks either in a tax-deferred or a conventional taxable savings account. Taxable bonds have a preferred location in the tax-deferred account and tax-exempt bonds have a preferred location in the taxable account for investors in sufficiently high tax brackets. Tax-efficient stock portfolios (e.g. passively-managed mutual funds) should be held in the taxable account and tax-inefficient stock portfolios (e.g. actively-managed mutual funds) should be held in the tax-deferred account. We show that locating assets optimally can significantly improve the risk-adjusted performance of retirement saving.

Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing

We investigate the optimal intertemporal asset allocation and location decisions for an investor with both taxable and tax-deferred investment opportunities. With unrestricted borrowing opportunities, the investor optimally allocates his entire tax-deferred wealth to taxable bonds and combines either borrowing or lending with investment in equity in the taxable account to achieve his optimal overall risk exposure. When the investor is prohibited from borrowing, the optimal asset allocation in his tax-deferred account may consist of both bonds and stocks, but only if the wealth in his taxable account is allocated entirely to equity. The preference for holding taxable bonds in the tax-deferred account and equity in the taxable account reflects the higher ordinary income on bonds and the tax avoidance strategies available on equity. The effect of liquidity shocks on the optimal asset location policy is also examined. Our results are in striking contrast to the asset location choices observed in practice.

Tax-Efficient Investing for Tax-Deferred and Taxable Accounts

Tax-Efficient Investing for Tax-Deferred and Taxable Accounts

Frequently Asked Questions Related to Savings Vehicles

The third in a series of articles on the interaction between tax and investment issues, this article starts with a simple example: projecting constant annual after-tax retirement incomes for each of four representative investors. Each investor can save in any five savings vehicles. This analysis also considers projected retirement incomes for low-cost and average-cost annuities and three investors who differ in how quickly they realize capital gains in the taxable account. The author then uses these retirement income projections to answer nine frequently asked questions related to savings vehicles. He concludes that deductible pensions and Roth IRAs are the best saving vehicles for bonds and for stocks, for all four hypothetical investors, and for all investment horizons, and offers several broad asset location rules.

The Courage of Misguided Convictions: The Trading Behavior of Individual Investors

Modern financial economics assumes that we behave with extreme rationality but we do not. Furthermore, our deviations from rationality are often systematic. Behavioral finance relaxes the traditional assumptions of financial economics by incorporating these observable, systematic, and very human departures from rationality into standard models of financial markets. This paper describes empirical tests of two predictions of behavioral finance: that investors tend to sell their winning stocks and to hold on to their losers and that, as a result of overconfidence, investors trade too much. Statman and Shefrin (1985) predict that investors will sell their winning investments too soon and hold on to their losers too long. They dub this tendency the disposition effect. Using account data from a large discount broker, we document that individual investors are 50 percent more likely to sell a winning investment than a losing investment (relative to their opportunities to do so). The analysis also indicates that many investors engage in tax-motivated selling, especially in December. Alternative explanations have been proposed for why investors might realize their profitable investments while retaining their losing investments. Investors may rationally, or irrationally, believe that their current losers will in the future outperform their current winners. They may sell winners to rebalance their portfolios. Or they may refrain from selling losers due to the higher transactions costs of trading at lower prices. When the data are controlled for rebalancing and for share price, the disposition effect is still observed. And the winning investments that investors choose to sell continue in subsequent months to outperform the losers they keep. This investment behavior is difficult to justify rationally; it is pure folly in an investor?s taxable account. It is difficult to reconcile the volume of trading observed in equity markets with the trading needs of rational investors. Rational investors make periodic contributions and withdrawals from their investment portfolios, rebalance their portfolios, and trade to minimize their taxes. Those possessed of superior information may trade speculatively, though rational speculative traders will generally not choose to trade with each other. It is unlikely that rational trading needs account for a turnover rate of 76 percent on the New York Stock Exchange in 1998. We believe there is a simple and powerful explanation for high levels of trading on financial markets: overconfidence. Human beings are overconfident about their abilities, their knowledge, and their future prospects. Odean (1998b) shows that overconfident investors trade more than rational investors and that doing so lowers their expected utilities. Greater overconfidence leads to greater trading and to lower expected utility. We present evidence that the average individual investor pays an extremely large performance penalty for trading. Those investors who trade most actively earn, on average, the lowest returns. And the stocks individual investors purchase do not outperform those they sell by enough to even cover the costs of trading. In fact, the stocks individual investors purchase, on average, subsequently underperform those they sell. This is the case even when trading is not apparently motivated by liquidity demands, tax-loss selling, portfolio rebalancing, or a move to lower-risk stocks. Our common psychological heritage insures that we systematically share decision biases that can lead to suboptimal investment behavior. Overconfidence provides the will to act on these biases. It gives us the courage of our misguided convictions.

Savings Vehicles and the Taxation of Individual Investors

This article is the first in a series of four, dedicated to the study of the broad issue of asset allocation. It is divided into two distinct sections. First the author introduces the overall study, discusses its general purpose and methodology, and reviews his overall broad conclusions. Second, he presents “Savings Vehicles,” a stand-alone article that focuses specifically on the issue of savings vehicles, asking how one should select a vehicle for the retirement portion of a household9s savings. The article first describes features of the five major savings vehicles in the U.S.: a personal or taxable account, a nondeductible pension, and a Roth IRA. It then presents the after-tax ending-wealth model for each vehicle and compares and contrasts the ending-wealth models.

Tax-Efficient Investing for Tax-Deferred and Taxable Accounts

Conceding that a great deal has been written about which asset classes are best held in a taxable compared to a tax-deferred account, the author looks at investors who have taxable and tax-deferred accounts of varying size, varying investment horizons, income tax brackets that are less than 39.6% or will decline below 39.6% upon retirement, complex asset allocation strategies using five asset classes, and investors who can hold their asset until death, getting the step-up in cost benefit. Starting with the ultimate goal to recommend asset allocation strategies that maximize after-tax returns, the article proposes a rule of thumb for allocating a variety of asset classes between the tax deferred and taxable portfolios. It concludes with a number of tables that offer a quick means to calculate tax liability without the benefit of a computer model and illustrate the asset allocation strategies discussed within the article.