Asset Allocation Over the Life Cycle: How Much do Taxes Matter?

Marcel Fischer, Holger Kraft, Claus Munk

Research output: Contribution to journalJournal articleResearchpeer-review

Abstract

We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2% of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems - a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.
We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2% of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems - a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.
LanguageEnglish
JournalJournal of Economic Dynamics and Control
Volume37
Issue number11
Pages2217-2240
ISSN0165-1889
DOIs
StatePublished - Nov 2013

Keywords

    Cite this

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    title = "Asset Allocation Over the Life Cycle: How Much do Taxes Matter?",
    abstract = "We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2{\%} of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5{\%}. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems - a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.",
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    Asset Allocation Over the Life Cycle : How Much do Taxes Matter? . / Fischer, Marcel; Kraft, Holger ; Munk, Claus.

    In: Journal of Economic Dynamics and Control, Vol. 37, No. 11, 11.2013, p. 2217-2240.

    Research output: Contribution to journalJournal articleResearchpeer-review

    TY - JOUR

    T1 - Asset Allocation Over the Life Cycle

    T2 - Journal of Economic Dynamics and Control

    AU - Fischer,Marcel

    AU - Kraft,Holger

    AU - Munk,Claus

    PY - 2013/11

    Y1 - 2013/11

    N2 - We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2% of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems - a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.

    AB - We study the welfare effect of tax-optimizing portfolio decisions in a life cycle model with unspanned labor income and realization-based capital gain taxation. For realistic parameterizations of our model, certainty equivalent welfare gains from fully tax-optimized portfolio decisions are less than 2% of present financial wealth and lifetime income compared to a heuristic portfolio policy ignoring the taxation of profits (capital gains, interest and dividend payments). Compared to a heuristic portfolio policy that only ignores the realization-based feature of capital gain taxation and instead assumes mark-to-market taxation, these gains are less than 0.5%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems - a wide-spread assumption in that literature. However, if capital gains are forgiven at death (as in the U.S.), investors with strong bequest motives face substantial welfare costs when not tax-optimizing their portfolio decisions towards the end of the life cycle.

    KW - Portfolio choice

    KW - Life cycle asset allocation

    KW - Taxation

    KW - Unspanned labor income

    U2 - 10.1016/j.jedc.2013.05.012

    DO - 10.1016/j.jedc.2013.05.012

    M3 - Journal article

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    JO - Journal of Economic Dynamics and Control

    JF - Journal of Economic Dynamics and Control

    SN - 0165-1889

    IS - 11

    ER -