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.
Original languageEnglish
JournalJournal of Economic Dynamics and Control
Volume37
Issue number11
Pages (from-to)2217-2240
ISSN0165-1889
DOIs
Publication statusPublished - Nov 2013

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.",
keywords = "Portfolio choice, Life cycle asset allocation, Taxation, Unspanned labor income",
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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 - How Much do Taxes Matter?

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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SP - 2217

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JO - Journal of Economic Dynamics and Control

JF - Journal of Economic Dynamics and Control

SN - 0165-1889

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ER -