Asset Allocation for Taxable Investor

In the presence of taxation, pretax, after-tax risk, and return characteristics may be significantly different. For this reason, taxable entities should consider after-tax characteristics during the allocation process. Adjusting for taxes after allocations have been made may lead to suboptimal allocations.

• Interest income is usually taxed at a higher rate than dividends or capital gains, and often at progressively higher rates. As a result, tax-exempt bonds (such as munis in the United States) may form a large part of a taxable investor’s fixed income allocation.
• Dividends are usually taxed at a lower rate than interest. Some investors may invest in preferred stocks in place of bonds for this reason.
• Capital gains are usually taxed at a lower rate than income, and capital losses can be used to offset capital gains elsewhere in the portfolio.
• Certain investment accounts may be tax deferred or tax exempt. The least tax-efficient (most heavily taxed) assets should be placed in the most tax-advantaged accounts.

After-tax portfolio optimization requires adjusting each asset class’s expected return and risk for expected tax. The expected after-tax return is:

• r_at = r_pt(1 – t)  

where

r_at = the expected after-tax return

r_pt = the expected pre-tax (gross) return

t = the expected tax rate

The expected return for equity typically includes both dividend income and price appreciation:

• r_at = p_dr_pt(1 – t_d) + p_ar_pt(1 – t_cg)  

where

p_d = the proportion of r_pt attributed to dividend income

p_a = the proportion of r_pt attributed to price appreciation

t_d = the dividend tax rate

t_cg = the capital gains tax rate

When an asset has a cost basis (for tax purposes) that differs from the market value, it has an existing unrealized gain (cost basis is below market value) or loss (cost basis is above market value). Unrealized gains imply an embedded tax liability and losses imply an embedded tax asset.

There are three potential ways in which the current market value may be adjusted to reflect the liability or asset.

1. Subtract the value of the embedded capital gains tax from the current market value of the asset as if it were to be sold today.
2. Assume the asset is to be sold in the future and discount the tax liability to its present value using the asset’s after-tax return as a discount rate.
3. Assume the asset is to be sold in the future and discount the tax liability to its present value using the after-tax risk-free rate.

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