Tax-Adjustment to Allocation

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Tax-Adjustment to Allocation

Postby newbeginning » Sat Mar 23, 2013 12:18 am

Should allocation be tax adjusted?

Example:

Roth IRA - Total Stock Market Index - $60,000
401k - Total Bond Market Index - $40,000 ($30,000 after taxes)
Marginal Tax Rate 25%

Would it be best to consider that a 60/40 or 67/33 Stock/Bond allocation?

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Re: Tax-Adjustment to Allocation

Postby mhc » Sat Mar 23, 2013 10:15 am

I think it is a personal preference. It is difficult to predict how much one will have to pay in taxes when withdrawing from retirement accounts in 20, 30, 40, 50, ... years.

There is a wiki article:
http://www.bogleheads.org/wiki/Tax-Adju ... Allocation
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Re: Tax-Adjustment to Allocation

Postby YDNAL » Sat Mar 23, 2013 10:39 am

newbeginning wrote:Should allocation be tax adjusted?

Example:

Roth IRA - Total Stock Market Index - $60,000
401k - Total Bond Market Index - $40,000 ($30,000 after taxes)
Marginal Tax Rate 25%

Would it be best to consider that a 60/40 or 67/33 Stock/Bond allocation?

Gene

Gene,

OK, I have some questions. You have mentally (perhaps on an Excel worksheet) accounted for 67% Stocks.
  • What do you do when $60K TSM takes a 50% hit?
  • Is the hit $30K or is it something else?
  • If you truly believed in a NEED to take only 60% Equity risk, would you adjust the Roth IRA to $56K TSM and $4K TBM?... does it make a difference?
Landy
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Re: Tax-Adjustment to Allocation

Postby Doc » Sat Mar 23, 2013 11:27 am

YDNAL wrote: If you truly believed in a NEED to take only 60% Equity risk, would you adjust the Roth IRA to $56K TSM and $4K TBM?... does it make a difference?[/list]


There is some difference between 60/40 and say 55/45 but probably not very much. One way to ease the adjustment mechanism that takes advantage of this "indifference" is to make your calculation once and adjust your "unadjusted" AA target number accordingly. Maybe your desired 50/50 adjusted allocation means your unadjusted allocation is 45/55. So you use the 45/55 and forget about it. Just make a note on your bring up calendar to do the calculation again in about five years.
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Re: Tax-Adjustment to Allocation

Postby dbr » Sat Mar 23, 2013 11:33 am

newbeginning wrote:Should allocation be tax adjusted?

Example:

Roth IRA - Total Stock Market Index - $60,000
401k - Total Bond Market Index - $40,000 ($30,000 after taxes)
Marginal Tax Rate 25%

Would it be best to consider that a 60/40 or 67/33 Stock/Bond allocation?

Gene


It is a 60/40 unadjusted allocation and a 67/33 adjusted allocation.

Your correct asset allocation is 60/40 unadjusted and 67/33 adjusted.

You cannot make changes to your investments based on this arithmetic unless you first explain by what method you arrive at asset allocations. You will have to explain how your method takes into account whether or not it is working with a tax adjusted allocation or an unadjusted allocation.
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Re: Tax-Adjustment to Allocation

Postby grabiner » Sat Mar 23, 2013 2:02 pm

What I do is to make all calculations in terms of this adjusted allocation.

For example, I would consider the OP's portfolio to be $60,000 in stock, and $30,000 in bonds, for an allocation of 67% stock. If the stock market loses half its value, the after-tax portfolio value drops to $60,000 and there should be $20,000 in bonds, so I would rebalance by moving $13,333 in the 401(k) (worth $10,000 after tax) from stock to bonds.

And the reason that I use this method is that the allocation is relative to what can be spent. If the stock market drops 50%, then the spendable value of the portfolio drops from $90,000 to $60,000, which means that the portfolio has the same risk as a tax-free portfolio which is 67% stock.
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Re: Tax-Adjustment to Allocation

Postby retiredjg » Sat Mar 23, 2013 2:33 pm

newbeginning wrote:Should allocation be tax adjusted?

I don't think so. But some people do. :wink:

Your portfolio is going to grow and shrink the same regardless of what kind of container it is in. For example, if you have half your money in Roth and half in tIRA...

    Roth IRA 50%
    50% Total Stock Market

    tIRA 50%
    50% Total Bond Market

will grow exactly the same as...

    Roth IRA 50%
    50% Total Bond Market

    tIRA 50%
    50% Total Stock Market

What's the point of adjusting numbers because one account has been taxed and the other has not? The portfolio value will be the same either way. And the true value of what you own includes the fact that some of it isn't really yours.

:( I realize this flies in the face of our more mathematically inclined members who really like to take things to the nth degree. My apologies are extended to you as well as true admiration for the energetic way you approach this stuff.

However, it just seems to me that tax-adjustment is an unnecessary burden and point of confusion for most people and I fear that some might feel they are "not doing enough" if they don't follow this practice.
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Re: Tax-Adjustment to Allocation

Postby YDNAL » Sat Mar 23, 2013 3:04 pm

Doc wrote:
YDNAL wrote: If you truly believed in a NEED to take only 60% Equity risk, would you adjust the Roth IRA to $56K TSM and $4K TBM?... does it make a difference?[/list]

There is some difference between 60/40 and say 55/45 but probably not very much.

NO material difference. Why would it matter to adjust for an assumed (unknown) tax bracket?... why stop there and not make an assumption of Inflation and its impact on Stocks vs. Nominal Bonds? IMO, we spend waaaaay too much time contemplating the unknown and trivial.

Doc wrote:One way to ease the adjustment mechanism....

Another more productive and worthwhile way is to focus on important things.... like getting that promotion at work, increasing savings rate, diversification, costs, etc.
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Re: Tax-Adjustment to Allocation

Postby learning_head » Sat Mar 23, 2013 3:06 pm

retiredjg wrote:For example, if you have half your money in Roth and half in tIRA [...] portfolio value will be the same either way.


From rest of your post, it sounds like you are counting based on nominal, not after-tax, value of your dollars when you say "half". If so, above statement would not normally be correct assuming a tax rate > 0 %

E.g.: if you start with nominal $100 in each Roth and tIRA, and assuming 25% tax on withdrawal, 10% stock, 5% bond appreciation, after 1 year...

Stocks in tIRA:
- $110 in tIRA, $105 in Roth
- after taxes: 110*0.75+105=187.5

Bonds in tIRA:
- $110 in Roth, $105 in tIRA
- after taxes: 105*0.75+110=188.75

So original $175 (after-tax) dollars grew by 7.14% in first case and 7.86% in the second case. Of course, that is because on after-tax basis, in first case you started with $75 in stocks and $100 in bonds, while in second case, $100 in stocks and $75 in bonds.

YDNAL wrote:Why would it matter to adjust for an assumed (unknown) tax bracket?


Because if you don't, you effectively ASSUME your tax bracket will be 0%...
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Re: Tax-Adjustment to Allocation

Postby YDNAL » Sat Mar 23, 2013 3:18 pm

learning_head wrote:
YDNAL wrote:Why would it matter to adjust for an assumed (unknown) tax bracket?... why stop there and not make an assumption of Inflation and its impact on Stocks vs. Nominal Bonds? IMO, we spend waaaaay too much time contemplating the unknown and trivial.

Because if you don't, you effectively ASSUME your tax bracket will be 0%...

It is not the "assumption", learning_head, it is the impact it makes.... not much, if any!!
1. BTW, I put back in blue the rest of the quote you chose to exclude.
2. Of course, each individual is free to make assumptions and corrections that float THEIR boat.
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Re: Tax-Adjustment to Allocation

Postby learning_head » Sat Mar 23, 2013 3:42 pm

YDNAL wrote:It is not the "assumption", learning_head, it is the impact it makes.... not much, if any!!
1. BTW, I put back in blue the rest of the quote you chose to exclude.
2. Of course, each individual is free to make assumptions and corrections that float THEIR boat.


If your tax will be 25% and you want 50/50 allocation, you would get 43/57 allocation instead by assuming 0% tax. I'll agree that size of this difference is something people can then decide for themselves... (In my random example, there was 0.72% return difference over a year - again, people can decide if that's important or not...)

I excluded blue text because I don't think it affects asset location in any way.
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Re: Tax-Adjustment to Allocation

Postby retiredjg » Sat Mar 23, 2013 4:49 pm

learning_head wrote:E.g.: if you start with nominal $100 in each Roth and tIRA, and assuming 25% tax on withdrawal, 10% stock, 5% bond appreciation, after 1 year...

Stocks in tIRA:
- $110 in tIRA, $105 in Roth
- after taxes: 110*0.75+105=187.5

Bonds in tIRA:
- $110 in Roth, $105 in tIRA
- after taxes: 105*0.75+110=188.75

So original $175 (after-tax) dollars grew by 7.14% in first case and 7.86% in the second case. Of course, that is because on after-tax basis, in first case you started with $75 in stocks and $100 in bonds, while in second case, $100 in stocks and $75 in bonds.

In either case, during accumulation you would have $215 in the portfolio at the end of the year (although some is not yours and will eventually be paid in taxes).

I'm not blind to your point learning_head :happy But...

    -people do move investments back and forth during the 20 to 40 years of accumulation,

    -there are many years when stocks do not outperform bonds and in those years, it seems this scheme would be counterproductive

    -the difference is pretty darn small,

    -tax law will undoubtedly change

    -I'm not sure your example proves what you think since it is not compared to a tax-adjusted portfolio; but it might be a good argument for holding stocks in Roth :happy

So I have to agree with Landy here (sound the trumpets!)...IMO, we spend waaaaay too much time contemplating the unknown and trivial.

I don't have any problem with people who want to do this. The reason I posted is that I'm concerned that some newer person might consider tax-adjusted portfolios as the norm and that would be incorrect. In fact I think it is probably the most confusing and least important of all the many possible things that might (or might not) make the portfolio a little tiny bit better.
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Re: Tax-Adjustment to Allocation

Postby YDNAL » Sat Mar 23, 2013 5:02 pm

learning_head wrote:I excluded blue text because I don't think it affects asset location [ :?: ] in any way.
I believe you meant "allocation" as that is what this thread is discussing.
YDNAL wrote:Why would it matter to adjust for an assumed (unknown) tax bracket?... why stop there and not make an assumption of Inflation and its impact on Stocks vs. Nominal Bonds? IMO, we spend waaaaay too much time contemplating the unknown and trivial.

Many different assumptions can impact your AA decisions.
Code: Select all
More INFLATION:
TSM $60K, 4%, 20 years, $131,500
TBM $40K, 2%, 20 years, $87,600 - 25% = $67,500
60/40 AA, projected $199,000

Less INFLATION:
TSM $33K, 6%, 20 years, $108,800
TBM $67K, 3%, 20 years, $121,000 - 25% = $90,800
33/67 AA, projected $199,600

Using OP's illustration, including inquiry to adjust for assumed taxes, assumptions on Inflation get you to relatively the same GOAL with significantly different Asset Allocations.
  • Why wouldn't expected REAL returns affect your Asset Allocation?
  • Is it because assuming taxes appears easier than assuming Inflation?
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Re: Tax-Adjustment to Allocation

Postby Ketawa » Sat Mar 23, 2013 5:25 pm

I like tax-adjusted asset allocation. It's not a big deal for most investors, but it results in more accurate planning. Some comments:

YDNAL wrote:Why wouldn't expected REAL returns affect your Asset Allocation?

They do, at least to the extent it helps an investor determine the need to take on risk. However, even if they didn't, IMO this is no reason not to use tax-adjusted asset allocation. If we can't do one thing accurately, or don't let it affect our asset allocations, it doesn't mean we should avoid doing something else that helps us maintain an asset allocation more accurately.

Is it because assuming taxes appears easier than assuming Inflation?

It is easier. If we can't forecast inflation accurately, this is not a reason to avoid using tax-adjusted asset allocation.


retiredjg wrote:-people do move investments back and forth during the 20 to 40 years of accumulation,

This is a reason for why investors should use tax-adjusted asset allocation. Using tax-adjusted asset allocation, it is possible to maintain the same risk level while changing investments between types of accounts instead of doing so without regard to taxes.

-there are many years when stocks do not outperform bonds and in those years, it seems this scheme would be counterproductive

It's not a scheme, just a way of accurately accounting for taxes. Nobody is suggesting that we market time between Roth and Traditional accounts.

-the difference is pretty darn small,

This could be true. Depends on the investor.

-tax law will undoubtedly change

This is true. However, I am pretty confident that my personal estimate of a 25% marginal tax bracket will be more accurate than assuming 0%.

-I'm not sure your example proves what you think since it is not compared to a tax-adjusted portfolio; but it might be a good argument for holding stocks in Roth

Using tax-adjusted asset allocation eliminates the purported reasons to hold higher returning assets in Roth. See: http://thefinancebuff.com/stocks-or-bonds-in-roth.html
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Re: Tax-Adjustment to Allocation

Postby YDNAL » Sat Mar 23, 2013 6:03 pm

Ketawa wrote:I like tax-adjusted asset allocation. It's not a big deal for most investors, but it results in more accurate planning. Some comments:

YDNAL wrote:Why wouldn't expected REAL returns affect your Asset Allocation?

They do, at least to the extent it helps an investor determine the need to take on risk. However, even if they didn't, IMO this is no reason not to use tax-adjusted asset allocation. If we can't do one thing accurately, or don't let it affect our asset allocations, it doesn't mean we should avoid doing something else that helps us maintain an asset allocation more accurately.

Is it because assuming taxes appears easier than assuming Inflation?

It is easier. If we can't forecast inflation accurately, this is not a reason to avoid using tax-adjusted asset allocation.

That makes no sense. IF YOU - individual investor Ketawa - require a high(er) level of accuracy in Asset Allocation decisions, then make ALL assumptions that provide (and impact) the most accurate result to achieve your projected goals.
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Re: Tax-Adjustment to Allocation

Postby retiredjg » Sat Mar 23, 2013 6:15 pm

It's not a scheme, just a way of accurately accounting for taxes. Nobody is suggesting that we market time between Roth and Traditional accounts.

I meant "scheme" in its best sense of the word, not the pejorative sense. As in "a plan, design, or program of action to be followed;" Never even considered what you suggested.


I like tax-adjusted asset allocation.

Then you should use it! :D

But don't assume it is easier or that it should make sense to everyone. It is not fundamentally easier and it doesn't make sense to all others. I don't even think you should assume it results in more accurate planning, but that is just my opinion, not fact. :wink:
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Re: Tax-Adjustment to Allocation

Postby Ketawa » Sat Mar 23, 2013 9:28 pm

YDNAL wrote:That makes no sense. IF YOU - individual investor Ketawa - require a high(er) level of accuracy in Asset Allocation decisions, then make ALL assumptions that provide (and impact) the most accurate result to achieve your projected goals.


It's not an all or nothing proposition. I'd venture to say that many of the investors on this site using age in bonds don't forecast anything about expected returns. They just reduce their allocation to stocks by 1% a year, and retire when they're comfortable with their porfolio's SWR.

Why can't someone do what I just described, add the appropriate tax adjustment to their asset allocation, and reap benefits such as not having to worry about asset location between Roth and Traditional accounts, or the hazards of switching asset classes between accounts?

I do forecast expected returns. However, I'm so far from retirement that it's difficult to say what my final target should even be. I have no idea what my expenses will be 30-40 years from now. In the meantime, I save as much as I can and stick to my tax-adjusted asset allocation.

retiredjg wrote:I meant "scheme" in its best sense of the word, not the pejorative sense. As in "a plan, design, or program of action to be followed;" Never even considered what you suggested.


Ok sorry for the confusion, my mistake :happy. I agree, it's not for everyone and may be needlessly complicated for many investors.
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Re: Tax-Adjustment to Allocation

Postby retiredjg » Sat Mar 23, 2013 9:47 pm

Ketawa wrote: I agree, it's not for everyone and may be needlessly complicated for many investors.

Why thank you! That's really the only point I was trying to make. I'm glad we agree. :happy
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Re: Tax-Adjustment to Allocation

Postby YDNAL » Sun Mar 24, 2013 10:07 am

Ketawa wrote:
YDNAL wrote:That makes no sense. IF YOU - individual investor Ketawa - require a high(er) level of accuracy in Asset Allocation decisions, then make ALL assumptions that provide (and impact) the most accurate result to achieve your projected goals.

It's not an all or nothing proposition. I'd venture to say that many of the investors on this site using age in bonds don't forecast anything about expected returns. They just reduce their allocation to stocks by 1% a year, and retire when they're comfortable with their porfolio's SWR.

You (the Boglehead poster) are either the *type of investor* who considers ALL assumptions that impact your AA decisions or you are not this type. At the end, as I've shown, the OP's 60/40 vs. 67/33 computation tells you absolutely nothing unless you attempt to determine this split (2-digit numbers notwithstanding) is best to get to your goal.

Ketawa wrote:Why can't someone do what I just described, add the appropriate tax adjustment to their asset allocation, and reap benefits such as not having to worry about asset location between Roth and Traditional accounts, or the hazards of switching asset classes between accounts?

I do forecast expected returns. However, I'm so far from retirement that it's difficult to say what my final target should even be. I have no idea what my expenses will be 30-40 years from now. In the meantime, I save as much as I can and stick to my tax-adjusted asset allocation.

Good for you! I only wished that adjusting a tax-deferred account meant anything (it doesn't) more than busy work. BTW, life is full of uncertainties and it is best to save the most we can to use when we no work/save.
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Re: Tax-Adjustment to Allocation

Postby dbr » Sun Mar 24, 2013 10:27 am

YDNAL wrote:You (the Boglehead poster) are either the *type of investor* who considers ALL assumptions that impact your AA decisions or you are not this type. At the end, as I've shown, the OP's 60/40 vs. 67/33 computation tells you absolutely nothing unless you attempt to determine this split (2-digit numbers notwithstanding) is best to get to your goal.


Right, without a discussion of how to arrive at an asset allocation, it is meaningless to try to choose between true and tax adjusted accounting.

It could be that there are methods of arriving at an AA that only make sense, meaning the AA is optimized with respect to some figure of merit, if some method, such as tax adjustment of values, is applied to devise an after tax figure of merit. I think that is the general idea in Reichenstein's papers. Without the full analysis, simply performing an alternate accounting is meaningless.
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Re: Tax-Adjustment to Allocation

Postby Doc » Sun Mar 24, 2013 11:53 am

dbr wrote:
YDNAL wrote:You (the Boglehead poster) are either the *type of investor* who considers ALL assumptions that impact your AA decisions or you are not this type. At the end, as I've shown, the OP's 60/40 vs. 67/33 computation tells you absolutely nothing unless you attempt to determine this split (2-digit numbers notwithstanding) is best to get to your goal.


Right, without a discussion of how to arrive at an asset allocation, it is meaningless to try to choose between true and tax adjusted accounting.

It could be that there are methods of arriving at an AA that only make sense, meaning the AA is optimized with respect to some figure of merit, if some method, such as tax adjustment of values, is applied to devise an after tax figure of merit. I think that is the general idea in Reichenstein's papers. Without the full analysis, simply performing an alternate accounting is meaningless.


I agree with both these ideas but I still advocate tax adjusting the balances because it corrects for changes in the growth rates of the various accounts. Without addressing "your share" of the account balances your AA may be changing without you even realizing it. Whether that change is enough to have any meaning may depend mostly on how good your 401k is.
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Re: Tax-Adjustment to Allocation

Postby newbeginning » Mon Mar 25, 2013 8:17 pm

YDNAL wrote:
newbeginning wrote:Should allocation be tax adjusted?

Example:

Roth IRA - Total Stock Market Index - $60,000
401k - Total Bond Market Index - $40,000 ($30,000 after taxes)
Marginal Tax Rate 25%

Would it be best to consider that a 60/40 or 67/33 Stock/Bond allocation?

Gene

Gene,

OK, I have some questions. You have mentally (perhaps on an Excel worksheet) accounted for 67% Stocks.
  • What do you do when $60K TSM takes a 50% hit?
  • Is the hit $30K or is it something else?
  • If you truly believed in a NEED to take only 60% Equity risk, would you adjust the Roth IRA to $56K TSM and $4K TBM?... does it make a difference?


1. Buy TSM if I had the funds, Sell TBM to buy TSM if not.
2. The hit would be $22,500 to me (because the rest would disappear to taxes the moment it was withdrawn). I guess that answers my own question.
3. I would be willing to adjust either account if necessary. Im somewhat confused by the proportions in the question. Wouldnt $56k TSM / $4k TBM (Roth) and $40,000 TBM (401k) be 56/44 unadjusted and 62/38 tax-adjusted (25% Tax Rate).

The accounts, balances, tax rates etc were hypothetical. It was an example to help me understand best practice.

Gene
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