An after-tax approach to allocation

Nov 5, 2007 @ 12:01 am

I want to make a case for calculating asset allocations in retirement accounts on an after-tax basis. First, consider 55-year-old Peggy, who is single and believes that she will be in the 25% marginal tax rate in retirement.

She has \$7,500 in a Roth individual retirement account and \$10,000 in a 401(k), and both are invested in the same stock fund, whose value we'll assume will double before withdrawal in retirement.

At that time, based on our assumptions, the Roth IRA will be worth \$15,000 after taxes, permitting Peggy to withdraw the funds and buy \$15,000 of goods and services.

Her 401(k) will be worth \$20,000 before taxes at withdrawal, or \$15,000 after taxes, also permitting her to buy \$15,000 of goods and services.

Whether the underlying investment earns 100% or 300%, or loses 20%, these accounts will buy the same amount of goods and services in retirement. Therefore, they should be considered equivalent today.

Generalizing, each \$1 of pretax funds in a tax-deferred account will buy the same amount of goods and services as (1-T) dollar of after-tax funds in a tax-exempt account, where T is the marginal tax rate in retirement.

Conceptually, it is useful to separate each pretax dollar in a tax-deferred account into two components: a (1-T) dollar of the individual's after-tax funds plus a T dollar, which is the government's share of the current principal.

Therefore, the \$10,000 in Peggy's 401(k) is like \$7,500 of her after-tax funds plus \$2,500, which is the government's share of the current principal.

The government effectively owns 25% of the current principal because it is like a silent partner that will get 25% of all withdrawals.

Let's change the example. Peggy now has \$500,000 of pretax funds in a 401(k) invested in stocks and \$375,000 of after-tax funds in a Roth IRA invested in bonds. If these are her only two investments, what is her asset allocation?

I recommend that she calculate her after-tax asset allocation. To do this, she must convert all market values to after-tax funds and then calculate the asset allocation based on the after-tax balances.

The \$500,000 in the 401(k) is worth \$375,000 after taxes. Using this approach finds that Peggy has \$375,000 of after-tax funds in stocks in the 401(k) and \$375,000 of after-tax funds in bonds for an overall after-tax asset allocation of 50% in bonds and 50% in stocks.

Using traditional measures, Peggy's \$875,000 in assets would show a 57% stock/43% bond asset mix.

I believe that using an after-tax approach to asset allocation in retirement accounts is a better way for advisers to add value. It distinguishes between pretax funds and after-tax funds, recognizing that taxes exist and that taxes have a very big effect on buying power.

By contrast, the traditional approach fails to distinguish between pretax and after-tax funds, and as a result can lead to a distorted idea of retirement purchasing power.

Of course, in calculating Peggy's after-tax asset allocation, we must estimate her retirement tax rate, which, in practice, is unknown. But even if we estimate that tax rate, it's still better to calculate an after-tax asset allocation than ignoring taxes completely.

By failing to distinguish between pretax and after-tax funds, the traditional way of calculating asset allocations in retirement accounts implicitly assumes a zero tax bracket in retirement. That of course is a delightful fantasy.

To repeat, calculating an after-tax asset allocation requires that the adviser convert the market values of all assets to their after-tax values and then calculate the asset allocation using these after-tax values.

Usually, the largest adjustment is the conversion of tax-deferred accounts' pretax values to after-tax values.

Some individuals may hold capital gains or losses in taxable accounts and may wish to adjust these assets' market values for the tax consequences of the gains and losses. But these adjustments are usually relatively small.

Despite the added complexity of doing these calculations, I recommend that financial advisers calculate individuals' after-tax asset allocations.

Doing so reflects the reality that taxes exist and enables advisers to give clients an apples-to-apples comparison of the funds in all their retirement accounts.

William Reichenstein, a chartered financial analyst, holds the Pat and Thomas R. Powers Chair in Investment Management at Baylor University in Waco, Texas.

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