• Basic Membership Access to Journal, Shadow Stock portfolio & monthly updates for stock screens
  • A+ Investor Full access to AAII.com, Journal, and a power data suite for investment ideas
  • AAII Platinum Full access to all of AAII's model portfolios and premium services at a significant discount
  • Dividend Investing Newsletter and model portfolio that focuses on dividend growth
  • AAII Growth Investing Find secular growth stocks poised for outperformance regardless of macroeconomic conditions.
  • Retirement Investing Discover trusted strategies for every stage of retirement. Get actionable insights and resources for smart retirement planning.
  • Sentiment Investing A research-driven newsletter with 10+ signals decoding sentiment across retail and institutional behavior.
  • Stock Superstars Report Get stock ideas inspired by the market's leading professionals
  • VMQ Stocks For the value investor looking to harness academic research in an actively managed portfolio
  • Bits and Bips Newsletter delivering insights on linking traditional finance, macro trends and cryptocurrency opportunities to help investors build stronger, more diversified portfolios.
All premium products come with free basic membership.
Explore All Membership Options
Join Now
Dispatches

Adjusting Target Asset Allocation to Correct for Impending Taxes

The consequence of ignoring taxes in a tax-deferred portfolio is holding an unintentionally riskier portfolio.

by Grace Malone | April 2024

The consequence of ignoring taxes in a tax-deferred portfolio is holding an unintentionally riskier portfolio.

Two researchers observed that the values of a dollar in a traditional IRA, a Roth IRA and an ordinary taxable account are not always equal. The tax properties for these accounts when assets are invested and withdrawn are different. The aftertax value of holdings inside traditional IRAs is less than the aftertax value of holdings in Roth IRAs or recently purchased assets in taxable accounts.

Figure 2. The Tax-Effect Drift

They note that the difference between aftertax asset allocation and standard, tax-blind asset allocation can be quite large. Assuming a 40% tax rate, a 60% stock/40% bond allocation with the stock portion in a traditional IRA is actually a 50%/50% stock/bond allocation after taxes. The researchers call this aftertax affect the tax-effect drift (Figure 2).

These observations led the researchers to develop artificial aim-points that adjust a target allocation for an aftertax setting. The metaphor of Kentucky windage is used to describe these adjustments. Windage is the practice of adjusting a rifle’s aim-point left or right to account for a crosswind that causes horizontal motion. Similarly, by setting an artificial pretax asset mix, the portfolio is able to achieve the target asset mix after taxes.

Source: “Kentucky Windage for Asset Allocation,” by William Jennings and Brian Payne; SSRN, January 15, 2024.

Discussion

DAVE G from TX posted over 2 years ago:

In my opinion Jennings and Payne turn a simple problem into a complex one which really can't be solved at the present for unknown conditions later in retirement. In the real world the financial planner cannot know whether the client can withstand the risk of a 70/30 portfolio or a 60/40 portfolio, so adjusting it up or down based on an unknown future tax rate is needless. Furthermore, having a large taxable account in itself is much worse from a tax perspective than getting your asset allocation wrong by 5-10%.


ROBERT A from NC posted over 2 years ago:

It took academic research to determine that a dollar in a Roth is worth more than one in a traditional IRA!? ?? That was obvious back in 1998 when I converted to a Roth.


You need to log in as a registered AAII user before commenting.
Create an account

Log In

Get your free copy of our special report analyzing the tech stocks most likely to outperform the market.
Download the FREE Report Here: