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Tax-Adjusted Asset Allocation

I wrote an article a couple weeks back discussing asset location–the question of which assets should go in which account (401k, IRA, taxable, etc.). Today I want to warn against a related mistake I’ve seen investors make when they ignore the differences between accounts–accidental asset allocation.

Remember, you’re going to have to pay taxes on your 401(k) and traditional IRA accounts when you withdraw your money.  So when you rebalance (or initially set up) your portfolio, you must account for the fact that only 75% or so of what’s in your 401(k) or traditional IRA will actually be yours to use.

For example…

Imagine that an investor plans to have a 60/40 stock/bond allocation and that he allocates his holdings as follows:

  • $40,000 in a Roth IRA–invested entirely in stock funds
  • $40,000 in a 401(k)–invested entirely in bond funds
  • $20,000 in taxable investment accounts–invested entirely in stock funds.

While this investor has $60,000 in stock funds and $40,000 in bond funds, he doesn’t exactly have a 60%/40% split. Why? Because he won’t get to keep all $40,000 from the 401(k). In effect, his actual asset allocation is something more along the lines of:

  • $40,000 in stock funds in his Roth (no taxes will come out of the Roth IRA when he withdraws the money)
  • $30,000 in bond funds in his 401(k) after adjusting for taxes (assuming a 25% effective tax rate in retirement)
  • $20,000 in stock funds in his taxable account.

As it turns out, this investor has $30,000 out of $90,000, or 33.3% in bonds. In other words, he has accidentally under-allocated bonds by a little more than 6%. Is this going to be a devastating mistake? Probably not. But it wouldn’t be that difficult to come up with some scenarios in which the tax-adjustment has an effect that’s large enough to worry about.

Two Additional Notes

Naturally, the effect of the necessary tax-adjustment is determined by what your marginal tax rate during retirement–something that’s impossible to know with certainty given the ever-changing nature of taxation. The greater you expect your tax rate to be, the more important it is for you to remember to make this adjustment.

In the above example, I assume that there will be no tax when the stocks/stock funds in the taxable account are sold. Obviously, this is not the case in reality. The reason I left it out of the calculation is that the degree of taxation depends entirely upon the investor’s cost basis–something that will vary dramatically from investor to investor.

Do you have to worry?

Of course, this whole issue isn’t a concern for you if you have excellent investment options in each account and you decide to split each account evenly so that they’re each composed of the same asset allocation you desire for your entire portfolio.

But what if, for instance, you only have one low-cost investment option in your 401(k)? If you forget to adjust for the tax bite that will be taken out of your 401(k), you’re likely to end up under-weighting whatever asset class it is that you’re 401(k) is invested in.

Bottom line: It’s worth taking a few minutes to look at your accounts to consider whether this is something you need to be concerned about.

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  1. I love my Roth 🙂 Although when my husband starts working, we’ll probably have to start thinking about a 401k.

  2. I wholeheartedly, and respectfully, disagree with this idea. As you pay the taxes, which won’t happen all at once, you simply adjust your overall allocation accordingly. You tax liability is your tax liability. It’s an expense like food, gas, entertainment, or any other, and while it’s attributable to a specific pool of assets, it doesn’t have to come from that pool of assets. If you make such an adjustment now, you will potentially overweight an asset class, changing the risk/return characteristics of your portfolio today. Your investments don’t know or care that you plan to pay taxes in the future.

  3. I agree with Dylan. Pay the tax with whatever money you want. It doesn’t matter upon what it is levied. It shouldn’t affect how you invest your money today.

    Just take this to an extreme. What if you were taxed at a rate of 99% in one type of account and your only option there was a good emerging markets fund. Do you adjust that fund balance upward by 1/0.99 ? That’s insane! This can’t be the right way to look at it.

  4. I didn’t meant 1/0.99 in that last post, just 0.99…

  5. TIE: For what it’s worth, in that scenario, that’s exactly what I’d do. That is, if “not investing in an account that would be taxed at 99%” was not an option. 😉

    If I had an account which I knew was going to disappear almost entirely once I decided I was going to use the money, I’d discount it accordingly when calculating my current asset allocation.

    Would that make my account statements look crazy for the time being? Yes.

    Would it make my stated combined account value particularly volatile? Yes.

    But what’s in that 99% tax rate account is almost entirely the government’s, for all intents and purposes. Only 1% of it is really going to be mine when I need it. The large fluctuations that would occur in that account due to its aggressive allocation would be almost meaningless to me, given that most of the money is going to disappear before I can use it.

  6. Oh. I misunderstood. So you meant that you should reduce your allocation in accounts to the extent they’re taxed?

    I’m trying to understand how you would operationalize your advice.

  7. Sorry for any lack of clarity. In your example, I would allocate the entire thing to the emerging markets fund. And I would only consider 1% of the account value when calculating my current asset allocation for rebalancing purposes.

  8. I think what is really going on is a conflict between tax efficiency and asset allocation. If one has very skewed options in both dimensions one gets crazy results. I think we can agree that putting nearly all one’s money in an emerging markets fund because it is taxed heavily makes no sense.

    I think it is much more likely that the typical investor has at least enough options under both vehicles (4o1(k) and Roth, say) that they can do a reasonable AA job in each. Maybe not perfect, but good enough. That being the case, one can optimize for tax efficiency independent of AA.

  9. Right, if an investor has suitable investment options in each account and chooses to invest in each account with a similar asset allocation, it’s a complete non-issue.

  10. It is a less non-issue than that. One can reallocate within the funds at the time of withdrawal. The tax can appear to be spread evenly across the asset classes even if the funds in the taxed account hadn’t been allocated that way. I think you’re saying this, I’m just re-saying it.

    To sum up, in a round-a-bout way I think the new idea in our exchange is that there is a balance between the two dimensions of constraints: AA and taxes. If both post a significant issue for one or another vehicle, then one needs to do some thinking. Juicing the account by the tax rate may be foolish (my 99% example).

  11. Put another way, when we look at our 401(k) balance we tend to focus on the value of the assets listed in the statement; we also need to include the associated tax liability that doesn’t appear in any statement

  12. I don’t disagree with the concept that the value of a tax deferred account is not equal to its purchasing power because of the deferred tax liability. But this should not cause you to gross up asset classes because they are implemented in such accounts over those implemented in other accounts.

    Here is another way to look at it using the example in the post. The total portfolio is worth $100,000, but after-tax it is only worth $90,000. You can apply you 60/40 allocation to the $90k that is yours and then apply it again to the $10K that is Uncle Sam’s. Then implement both of those allocations in the most favorable, tax-advantaged accounts. Some of Uncle Sam’s money will be invested in stocks in the taxable account, but so what? If you think it matters, lay it out on a spreadsheet, and you will see it does not.

  13. After receiving a little disagreement here, I went to the Bogleheads forum and asked their thoughts on the matter. In case anybody is curious, the thread can be found here:

    Also, one Mike P shared this link from the Bogleheads wiki:

  14. It’s a pretty complicated issue. Consider just allocation between a Roth and taxable accounts. On the one hand, I want my best performers (probably stocks) to be in the Roth. On the other hand, I want the bonds to be in the Roth because they are tax inefficient.

    Then there’s the dilemma about where to hold emerging markets stocks. Assume we have a hunch EM stocks will outperform. To avoid capital gains, hold them in the Roth. But to claim foreign tax deduction, you want them in the taxable.

    Throw in a 401k, a few more securities, and perhaps limited investment options in some accounts, and it all gets very complicated. If someone could show scenarios where one strategy is clearly preferred over another, that might be useful.

  15. Let me try to approach this from another, more practical angle. Hopefully, we all agree that asset allocation has the greatest influence on long-term returns. Many folks may start out in their 20s or 30s with a majority stock allocation, investing and not withdrawing. As the decades pass, they may scale back their equity allocation once they no longer benefit from as much equity exposure. By the time they begin taking distributions from tax-deferred accounts (and paying some taxes) in their 60s or 70s, they may very likely have minority stock allocation. If, along the way, they constantly discounted tax-deferred money and grossed up the asset class allocation implemented with that money, they will have spent a half-century, give or take, with a different risk/return profile than actually desired (likely more conservative because bonds are favored in the tax-deferred account).

    But it doesn’t stop there. Whether or not they use a “tax-adjusted” allocation, they will still have to pay the taxes on distributions from the tax deferred accounts (each distribution will likely be only a small amount relative to the total balance). Assuming the amount of the distribution is the same in either approach, the taxes will also be the same. If they are diligent in rebalancing, even using the cash out-flow to minimize to assist, they can maintain their desired target allocation post distribution. So the potential for a few more decades of experiencing the pre-tax risks and rewards of the adjusted allocation continues. So where exactly is the benefit of adjusting the allocation for tax-deferred assets? The detriment is multiple decades of actual exposure to a different risk/return profile than what was actually intended.

  16. “to minimize to assist” should just be “to assist.” Two thoughts collided and neither correctly emerged 🙂

  17. Dylan, you say that “the detriment is multiple decades of actual exposure to a different risk/return profile than what was actually intended.”

    As far as I can tell, that’s precisely the detriment of not tax adjusting.

    To me, if an investor expects a 25% tax bracket in retirement, then that means that he only benefits to the extent of 75% of the assets in his 401k. It seems to me that it follows that he must adjust everything that happens in that account to the degree of 25%.

    For example, he’s only affected to the extent of 75% of fluctuations in the account value. To ignore that seems to set him up for a different risk/return profile than intended.

  18. Mike, I get where you’re coming from, but that deferred tax is a future liability, no matter how you’re allocated. You can think of tax-deferral as a loan. While you have it, it’s yours to benefit from it for as long as you have it. Then you pay it back according to the agreed upon terms in the future. It’s really not that different from any other leverage that allows you to keep more money in an account, like a home mortgage. Yes it’s structured differently, but it’s still money you can use for an extended term.

    If your desired allocation is 60/40 and you adjust so you end up being closer to 50/50, your long-term returns will reflect a 50/50 allocation and then, sometime in the future, you pay taxes. If you don’t adjust, your long-term returns will reflect the 60/40 allocation and then, sometime in the future, you pay taxes.

    Also (and I think this probably one of the most compelling arguments), by adjusting as you proposed, you are essentially deciding to account for and invest a separate pool of funds specifically to meet far-off, future tax liabilities from retirement account distributions 100% in bonds.

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