When Taxes Collide With Your Asset Allocation

Here's a mind-bender for you.

Let's say a 65-year-old woman is prepping her portfolio for retirement. Her assets are ultra-streamlined, with a $500,000 Roth IRA account containing stocks and $500,000 in a traditional IRA portfolio consisting of bonds.

Is her asset allocation:

a) 50% bonds and 50% stocks

b) Heavier on stocks than bonds

c) Both of the above statements are true.

The correct answer, at least from a practical standpoint, is C.

Say what?

On the surface, her asset allocation is indeed an even 50/50 split. Remember, however, that she's going to have to pay taxes on any withdrawals from her traditional IRA accounts. Because that whole bond portfolio will be taxed at her ordinary income tax rate when she withdraws her money, from a practical standpoint, her portfolio has a heavier equity than bond weighting, even though the pretax weighting is 50/50.

Assuming her tax rate is 25% throughout her retirement (a pretty big assumption), her tax-adjusted asset allocation is closer to 42% bonds/58% stocks. That's because her traditional IRA portfolio's tax-adjusted dollar value is actually $375,000 ($500,000 taxed at 25%); $375,000 is just 42% of her total tax-adjusted portfolio value of $875,000. We don't need to make any adjustments to her Roth portfolio, because she's already paid tax on that money. Her $500,000 Roth portfolio--all stocks--therefore accounts for 58% of her portfolio. Thus, her balanced portfolio isn't quite as balanced as it looks.

Of course, this example was an easy one--withdrawals from the traditional IRA are taxed at the investor's ordinary income tax rate, while the Roth withdrawals are not. In reality, many investors also hold a third type of assets--taxable assets where you won't owe taxes on your basis--the amount you put in--but you will owe tax on any dividends, income, and capital gains your accounts generate over the time you hold them. Those dividend, income, and capital gains taxes are less predictable than the taxes you'll owe on distributions from your traditional IRAs and 401(k)s, but some experts suggest that it's reasonable to assume a similar tax haircut for taxable assets as you do for what you hold in your traditional IRAs and 401(k)s.

Those tax repercussions underscore the importance of factoring tax effects into your analysis of your own asset allocation, just as you should factor the tax effects into your evaluation of your own retirement readiness. The bottom line, as I discussed in this article, is that objects in your traditional IRA and 401(k) accounts, as well as your taxable holdings, are smaller than they actually appear. If you're gauging the viability of your retirement plan--or using online tools to help you do so--it's important that you pick up on these tax effects, because they can be significant. The Bogleheads Wiki site links to a useful spreadsheet that can help you get your arms around your tax-adjusted asset allocation.

Before you invest too much time in the number-crunching, however, it's worth bearing a few caveats in mind, which in turn can help you decide how much weight to place on this issue.

It's About Balance
The more your investments are balanced between accounts that will be taxed on distribution, such as traditional IRAs and 401(k)s, and those that will not, such as Roths, the bigger deal this issue is likely to be. My example above was pretty stark. But let's say another individual has $900,000 of his nest egg in his 401(k), all equities, and another $100,000 in Roth assets, all bonds. His pretax allocation is 90% equity/10% bonds. Tax-adjusting his asset allocation isn't a huge deal; his equity weighting drops to 87% once we tax-adjust his 401(k) holdings (assuming a 25% tax rate), and his bond position is 13%. His 401(k) money will be worth just $675,000 upon withdrawal, accounting for 87% of his $775,000 tax-adjusted balances in both accounts.

Tax-adjusted asset allocation will also tend to make little difference if you've balanced all of your account types across stocks and bonds. For example, assume a person has $750,000 in a Roth and $250,000 in a traditional IRA, with each portfolio split evenly between stocks and bonds. The pretax and aftertax asset allocations are identical--50/50--because both the stock and bond withdrawals from the traditional IRA are reduced by the same tax rate.

That's not to suggest that you should necessarily keep each of your sub-portfolios evenly balanced, however. In fact, housing various asset types in certain types of accounts to limit the tax collector's cut of your return on a year-to-year basis--holding bonds in tax-sheltered accounts, for example--is one of the simplest things you can do to boost your portfolio's long-term returns. Rather, the examples illustrate that the concept of tax-adjusted asset allocation will be more important for you if your situation is similar to my first example--your money is equally balanced between assets that will be taxed and those that will not, and your different accounts skew heavily toward a single asset class.

More Important for Retirees and Pre-Retirees Than Accumulators
In addition, the concept of tax-adjusted asset allocation becomes more important as you approach retirement and actually begin making withdrawals from your various pools of money. Not only are young accumulators' asset allocations apt to look completely different by the time they begin taking taxable withdrawals from their traditional IRAs and 401(k)s, but so will the size of their various pots of money and what types of assets they hold in each. Tax rates are likely to be different, too. Tax-adjusted asset allocation is worth keeping on their radar, but attempting to calibrate their aftertax asset allocations with precision isn't likely to be a good use of their time.

By contrast, the closer you get to retirement, the more real those tax-adjusted withdrawals become. Not only are you paying taxes on capital gains and dividends generated by your taxable accounts, just as investors of all ages do, but you're paying ordinary income tax on your traditional IRA and 401(k) withdrawals. Thus, as you approach retirement, it becomes more valuable to view your asset allocation not just in isolation, but factoring in the tax effects as well. If your portfolio is substantially more aggressive or conservative than was your aim once tax effects are factored in, you can make adjustments to which types of assets you hold in which types of accounts.

There Are Still Wild Cards
Yet even retirees who are close to withdrawing their money will have to make some pretty big assumptions when thinking through their tax-adjusted allocations. First, their accounts aren't likely to remain static from year to year: Both portfolio withdrawals and gains or losses will also have a big hand in changing their asset allocations on an ongoing basis, as will asset-allocation shifts made by active portfolio managers they might employ. Thus, their tax-adjusted asset allocations are apt to bump around quite a bit.

An even bigger wild card in your tax-adjusted asset allocation analysis is that we don't even know what income, dividend, and capital gains tax rates will be next year, let alone in the decades ahead. Although income tax rates are set to go up in 2013, Congress could make some adjustments before it's all over. Moreover, it's worth noting that your personal tax rate may change from year to year, apart from what happens with tax rates at a macro level. Thus, it can be difficult to decide exactly how much of a tax haircut to give your taxable and traditional IRA and 401(k) assets when attempting to figure out your tax-adjusted asset allocation.

All the same, no one's suggesting taxes will be going away anytime soon, and there's a good case to be made for them going up. So unless your assets are held entirely in Roth accounts, minding the intersection between your asset allocation and taxes is a worthwhile dimension in your portfolio plan.

See More Articles by Christine Benz