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Asset allocation over the life cycle: How much do taxes matter?

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  • Fischer, Marcel
  • Kraft, Holger
  • Munk, Claus

Abstract

We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2% of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems – a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.

Suggested Citation

  • Fischer, Marcel & Kraft, Holger & Munk, Claus, 2013. "Asset allocation over the life cycle: How much do taxes matter?," Journal of Economic Dynamics and Control, Elsevier, vol. 37(11), pages 2217-2240.
    • Handle: RePEc:eee:dyncon:v:37:y:2013:i:11:p:2217-2240
    DOI: 10.1016/j.jedc.2013.05.012
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    More about this item

    Keywords

    Portfolio choice; Life cycle asset allocation; Taxation; Unspanned labor income;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies

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