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William J. Bernstein

Do Your Asset Classes Care Where They Are?


From time to time I get asked whether a dollar of a given asset class in a tax-sheltered account is equivalent, for the purposes of policy allocation, to a dollar in a taxable account. Let’s take, for example, someone who owns a simple 50/50 portfolio of stocks and bonds in a portfolio equally divided between taxable and IRA accounts. The most intelligent way to allocate investments is to place the stocks in a tax-efficient vehicle on the taxable side and the bonds in the sheltered half.

Let’s further assume that this individual’s combined federal, state, and local tax bracket is 33.3%. Does this individual in fact own a 60/40 portfolio, since one third of the bonds will be taxed away upon distribution? (If he had $150,000 each in the taxable stock and sheltered bond accounts, and assuming that he has accrued no capital gains in the stock portion—a reasonable assumption after the recent market decline—then he has a total of $250,000 in after-tax assets: $150,000 in stocks and $100,000 in after-tax bonds.)


Let’s suppose that our retiree has just read The Coming Generational Storm and has concluded that marginal tax rates are due to increase dramatically and thus wants to draw down his sheltered account first. Further assume that he needs $20,000 in living expenses in the coming year. In this case, he distributes $30,000 from his sheltered account, pays $10,000 in taxes, and is left with the required $20,000. His portfolio now contains $270,000 in total assets. To stay at 50/50 he must exchange $15,000 in his taxable account into taxable or municipal bonds. Contrariwise, if he is not concerned with rising marginal rates, he can sell $20,000 of his stocks, in which case he now has $280,000 in total assets and must exchange $10,000 from bonds to stocks in his sheltered account.

Both of these transactions are mathematically equivalent in after-tax dollars. To drive home the point, were he to exchange all of his stocks for bonds in the taxable account and all of his bonds for stocks in the sheltered account, does he now own a 40/60 portfolio? Likewise, of course not.

Thus, to the extent that asset classes in sheltered and taxable accounts are fungible—that is, freely exchangeable—it makes no sense to discount sheltered dollars by the ordinary tax rate (and taxable dollars according to the proportion of capital gains due). Of course, one must still discount the total value of the portfolio according to the total amount of tax due, but it makes no sense to do this to individual asset classes according to their physical location.

However, this is not true if an asset class cannot be owned, at the margin, in a taxable account. The two best examples of this are junk bonds and REITs, which yield almost all of their long-term return in the form of dividends; if one is in a high tax bracket, one does not have the option of selling a REIT in a sheltered account and buying it back in a taxable one. Theoretically, this might become a problem if you have only 5% of the portfolio in sheltered assets, have put every last cent of it into REITs, and decided to tap your sheltered account first. Only in this rather unusual situation would it make sense to discount the sheltered account.

The other problem arises because of the future composition of your accounts. While fungible asset classes held in taxable and sheltered accounts are equivalent in the present, this doesn’t hold if the future returns of the two pools are greatly different. In particular, if your sheltered portfolio grows much faster than your taxable account, then a higher percentage of taxes will be due. Again, this is not a practical consideration; the most rational way to partition a portfolio with roughly equivalent taxable and sheltered accounts is to put most of the stocks on the taxable side, which will gradually reduce the relative tax burden of the portfolio.

Of course, all this is the accounting equivalent of rearranging deck chairs on the Titanic, paling into insignificance against the importance of future tax rates. Given the gargantuan unfunded liabilities of Social Security (about $5 trillion) and Medicare (at least $40 trillion), if you offered me a 45% marginal rate on my IRA withdrawals twenty years hence, I’d give it about as much thought as Donald Trump gives a job evaluation before I took the money and ran.

In most cases, your assets don’t know or care where they are. By all means, discount your total portfolio by the total amount of taxes due. But, except in rare circumstances, you don’t have to tie yourself into pretzels discounting each asset class according to its location.


Needless to say, not everyone agrees with this formulation. Professor William Reichenstein, who holds the Thomas R. Powers Chair in Investment Management at Baylor University, cogently makes the opposite case in an article published in the Journal of Wealth Management in 2001. As a rebuttal, he has graciously allowed me to link to this piece, a well-written and oft-quoted article that makes the case that differential tax treatment mandates adjustment of the calculation of allocation. Readers are invited to consider both sides of this debate and draw their own conclusions.

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