After Tax Asset Allocation

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humblecoder
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After Tax Asset Allocation

Post by humblecoder »

I have read and digested the wiki page about "Tax Efficient Placement" (https://www.bogleheads.org/wiki/Tax-eff ... _placement) and it generally makes sense to me. However, I did not see any discussion of how the asset allocation is impacted by the tax treatment of where you are placing the assets. It is probably easier to explain with an example.

Let's say for simplicity that I have a $100K portfolio and I want to have a 50/50 asset allocation. Based upon what I read in the tax efficient placement wiki page, I would want to put $50K into a Bond Fund in a tax deferred account and $50K into a Stock Fund in a taxable account. This gives me a 50/50 allocation on paper. However, if I have a tax rate of 20%, that $50K in the tax deferred Bond Fund is really only worth $40K after taxes, whereas the $50K in the taxable Stock Fund is still worth $50K*. That means that I have an effective after tax asset allocation of 55/45, which is more risk than I had intended to take.

Am I correct in my analysis or is there some flaw in my thinking? If I am correct, how do people account for this (if at all)?

* - I assumed no cap gains in order to simplify the example to get my point across, but even if there are cap gains, you'd have the same effect due to differences between the ordinary rate and cap gains rate and the fact that not all $50K would be subject to cap gains.
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mhc
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Re: After Tax Asset Allocation

Post by mhc »

There is a wiki page on this:
https://www.bogleheads.org/wiki/Tax-adj ... allocation

Your point is valid. I do not follow a tax adjusted AA for several reasons:
1. I don't think it will have much influence on my financial well being
2. I don't want to put in the work to look at it this way
3. I don't know my future tax rate

I do keep it in the back of my mind that I will have to pay taxes on my 401k when I withdraw the money.
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Cyclesafe
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Re: After Tax Asset Allocation

Post by Cyclesafe »

IMHO the main reason to set an asset allocation is to commit to a level of equity risk. Whether the allocation is before or after a indeterminable future tax is of secondary concern. The equity risk, either way, is the same even though its calculation yields a different figure.
"Plans are useless; planning is indispensable.” (Dwight Eisenhower) | "Man plans, God laughs" (Yiddish proverb)
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Doc
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Re: After Tax Asset Allocation

Post by Doc »

mhc wrote: Tue Nov 10, 2020 1:02 pm There is a wiki page on this:
https://www.bogleheads.org/wiki/Tax-adj ... allocation

Your point is valid. I do not follow a tax adjusted AA for several reasons:
1. I don't think it will have much influence on my financial well being
2. I don't want to put in the work to look at it this way
3. I don't know my future tax rate

I do keep it in the back of my mind that I will have to pay taxes on my 401k when I withdraw the money.
One quick and easy way to handle this "problem" is just to adjust you asset allocation for the fact that you don't "own" 100% of your tax deferred account.

Example:

Desired AA of 50/50
All 50 of you FI is in tax deferred so maybe 10K is the Guv's not yours so your AA after tax is 50/40.
So just change that 50/50 to say 40/60 pretax which is ~50/48 after tax.
Close enough to what you wanted in the first place.
You can work out the details for your own case but you might only have to revise the calc every five to ten years.
Remember that "best" AA is a wishy washy thing in the first place.

After you've done that once or twice just use mh's' three points.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.
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