Academic journal article Financial Services Review

Implications of Principal, Risk, and Returns Sharing across Savings Vehicles

Academic journal article Financial Services Review

Implications of Principal, Risk, and Returns Sharing across Savings Vehicles

Article excerpt

Abstract

This study illustrates that the choice of savings vehicles [e.g., taxable account, Roth IRA, or tax-deferred accounts such as a 401(k)] affects the portions of principal effectively owned by, returns received by, and risk borne by individual investors. This study examines the implications of this analysis for (1) the calculation of an individual's asset allocation, (2) mean-variance optimizations, and (3) asset location. For example, it illustrates problems when traditional mean-variance optimization is applied to an individual's portfolio. Separately, there is broad agreement among scholars that we should distinguish between pretax funds and after-tax funds when calculating an individual's asset allocation. This study suggests an approach to measuring an individual's asset allocation. © 2007 Academy of Financial Services. All rights reserved.

JEL classification: G11, G12, G23

Keywords: Asset allocation; Mean variance optimization; Asset location

1. Introduction

This study illustrates that the choice of savings vehicles [e.g., taxable account, Roth IRA, or tax-deferred accounts such as a 401(k)] affects the portions of principal effectively owned by, returns received by, and risk borne by individual investors. The analysis has implications for (1) how we should perform mean- vari anee optimizations for individual investors, (2) the asset location decision, and (3) how we should calculate an individual's asset allocation.

For example, an individual investor in the 25% tax bracket receives all returns and bears all risk on bonds held in Roth IRA, but he receives only 75% of returns and bears about 75% of risk on bonds held in a taxable account. The upshot is that in mean-variance analysis bonds held in a Roth IRA are effectively a different asset than bonds held in a taxable account. This study contrasts traditional tax-oblivious mean-variance analysis with an after-tax mean-variance analysis. The differences between returns-sharing and risk-sharing across savings vehicles helps explain the asset location argument that, in general, bonds should be held in Roth IRAs and tax-deferred accounts and stocks should be held in taxable accounts.

Separately, the analysis has implications for the calculation of an individual's asset allocation. Reichenstein (1998), Reichenstein and Iennings (2003), Horan (2002), and Sibley (2002) among others agree that the traditional approach to calculating an individual's asset allocation is wrong because it fails to distinguish between after-tax funds in a Roth IRA and pretax funds in a tax-deferred account. However, these authors disagree about how we should value $1 in a Roth IRA and $1 in a tax-deferred account when calculating an individual's current asset allocation. Reichenstein (1998) and Reichenstein and Iennings (2003) argue that $1 in a Roth IRA should have a current value of $1, whereas $1 in a tax-deferred account should have a current value of (1 - t^sub n^) dollars, where t^sub n^ is the expected tax rate upon withdrawal during retirement. Sibley (2002) and Horan (2002) argue that we should calculate these accounts' taxable equivalent values. The taxable equivalent value of a Roth IRA is the amount of funds in taxable accounts that will produce the same after- tax future value as the Roth IRA. The taxable equivalent value of a tax-deferred account is defined in a parallel fashion. Sibley and Horan argue that we should use the taxable equivalent values of Roth IRAs and tax-deferred accounts when calculating an individual's current asset allocation. This study uses the risk-sharing analysis discussed earlier to review Sibley and Horan's approach and to support Reichenstein and Jennings' after-tax approach to measuring an individual's asset allocation.

There are five additional sections to this study. Section 2 develops models of after-tax future values per current dollar in TDAs, Roth IRAs, and taxable accounts. It then uses these models to illustrate how the choice of savings vehicles affects the portions of principal effectively owned by, returns received by, and risk borne by individual investors. …

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