Generating Tax Alpha With After-Tax Asset Allocation
The calculation of after-tax asset allocation is key to determining asset location, which can significantly impact an investor’s after-tax returns according to a study done by William Reichenstein, Ph.D., CFA (a copy is here as well). Reichenstein proposes a unified framework that addresses the different risks and returns that exist between taxable and retirement accounts. While he doesn’t mention the term “tax alpha” explicitly, it discusses some interesting tax management issues. The paper peaked my interest due to my experience with developing technology and product strategy around managed accounts, which have strong tax benefits.
Reichenstein recommends converting all account values to after-tax funds and then calculating the asset allocation based on these values.
The paper states that any cash management algorithm that splits incoming funds between taxable and non-taxable account should take future taxes into account. Funds being directed into a tax-deferred account, like a 401(k), should be adjusted by the future taxes the client would expect to pay in retirement. This calculation would be performed by multiplying the amount by (1 – tn), where tn is the expected tax return in retirement.
For example, if a client expects to be in the 25% tax bracket when they retire (assuming there is such a low bracket by that time) the pre-tax funds would be multiplied by 75% (1 – 25%) to account for future taxes.
A client with $200,000 to invest between a tax-deferred and taxable account should not put $100,000 into each account, since it would not be an equal allocation using this method. They would need to put around $114,000 into the tax deferred and the remaining $86,000 into the taxable account.