Two Key Concepts for Wealth Management and Beyond (corrected March 2012)

Asset allocation is profoundly influenced by at least two underappreciated concepts. First, tax-deferred accounts—for example, 401(k)s—are like partnerships in which the investor owns (1 – tn) of the partnership principal and the government owns the remainder, where tn is the marginal tax rate when the funds are withdrawn. Second, the government shares in both the return and the risk of assets held in taxable accounts. The authors discuss these concepts’ implications for wealth management.In this study, we presented two key concepts and discussed some of their investment implications. The first concept is that a tax-deferred account (TDA), such as a 401(k), is like a partnership in which the investor owns (1 – tn) of the partnership principal and the government owns the remaining tn of principal, where tn is the marginal tax rate when the funds are withdrawn. The second concept is that the government shares in both the return and risk of assets held in taxable accounts, unlike funds in TDAs or tax-exempt accounts (e.g., Roth IRAs). These concepts have important implications for several areas in wealth management.The after-tax value of funds in a tax-deferred account grows tax exempt. The calculation of an individual’s or a couple’s asset allocation should be based on after-tax balances in each savings vehicle. In contrast, the traditional approach fails to distinguish between pretax and after-tax dollars.When calculating an individual’s or a couple’s asset allocation, pretax balances in TDAs should be converted to after-tax dollars by multiplying the pretax balances by (1 – tn).There is an optimal asset location, which is inextricably linked to portfolio optimization. Individuals should locate lightly taxed securities in taxable accounts and heavily taxed securities in tax-advantaged retirement accounts to the highest degree possible, while maintaining their risk–return preference.The main factor in the decision to save in a tax-deferred account or a tax-exempt account is a comparison of the marginal tax rates in the deposit year and in the withdrawal year. In general, if the expected marginal tax rate in retirement is lower than this year’s tax rate, then the individual should save in a TDA, and vice versa.Similarly, the most important factor in a Roth conversion decision is the comparison of the marginal tax rates in the conversion year and in the withdrawal year in retirement. If this year’s marginal tax rate is lower than the withdrawal tax rate, it pays to convert funds to a Roth account this year. The optimal conversion amount would push an investor to the top of the tax bracket just below his or her estimated marginal tax rate in retirement. To convert all of an individual’s pretax TDAs to after-tax dollars in the same year is seldom appropriate.Suppose a U.S. retiree faces a 25 percent marginal tax rate. To make the portfolio last as long as possible, he or she generally should withdraw funds from taxable accounts before TDAs or tax-exempt accounts. This rule has exceptions, however, most of which are based on our first key concept.For estate tax planning, choosing whether to gift or bequeath assets is analogous to choosing between a traditional IRA and a Roth IRA—that is, a comparison of the tax rates today and those expected in the future is the critical factor.