Tax Considerations in Asset Allocation and Rebalancing

Commonalities Among Global Tax Codes

As a global institution, CFA Institute^® does not obligate candidates to study the tax codes of specific jurisdictions. However, certain commonalities in tax treatment are widely applicable and essential for the exam and the candidate’s knowledge enhancement. These commonalities encompass:

• Favorable tax treatment of capital gains in comparison to interest income.
• Preferential tax treatment of dividends in contrast to intereast income.
• Tax advantages for capital gains compared to earned income.
• The existence of various tax-deferred or tax-exempt accounts.

By familiarizing themselves with these widespread tax principles, candidates can gain a valuable understanding of the general tax considerations relevant to investment decisions and financial planning.

After-Tax Portfolio Optimization

An asset’s expected return and risk are adjusted to account for expected taxes. In the case of bonds, the expected after-tax return can be calculated as follows:

$$ r_{at} = r_{pt}(1-t) $$

Where:

• \(r_{at}\)=Expected after-tax return.
• \(r_{pt}\)=Expected pre-tax (gross) return.
• \(t\)=Expected tax rate.

Optimizing after-tax considerations for bonds is relatively straightforward because the return is primarily derived from interest income. However, the process becomes more complex when dealing with equities due to including capital gains as part of the expected return.

The expected after-tax return equities are expressed as:

$$ r_{at}=p_d r_t(1-t_d)+p_ar_{pt}(1-t_{cg}) $$

Where:

• \(r_{at}\)=Expected after-tax return.
• \(p_d\)=Proportion of \(r_{pt}\) attributed to dividend income.
• \(p_a\)=Proportion of \(r_{pt}\) attributed to price appreciation.
• \(t_d\)=Dividend tax rate.
• \(t_{cg}\)=Capital gains tax rate.

Example: Calculating Expected After-Tax Return for Equities

An investor is subject to income tax at a rate of:

• 20% on dividend income.
• 15% on capital gains.

The pre-tax return is expected to be 10%.

• 20% of pre-tax return is expected to be realized through dividend income.
• 80% of pre-tax return is expected to be realized as price appreciation (capital gains are assumed to be realized annually).

Calculate the after-tax return to be used in the asset allocation process:

Solution

Formula:

$$ r_{at}=p_d r_t(1-t_d)+p_ar_{pt}(1-t_{cg}) $$

Where:

$$ r_{at} =0.20 \times 0.10(1-0.20)+0.80 \times 0.10(1-0.15)=0.084=8.40\% $$

Adjusting for Built-in Taxes of Capital Gains

While tax considerations do not impact correlations between assets, assessing risk and return from pre-tax and post-tax perspectives is essential. This is because taxes can affect the volatility of investments in a taxable account through the payment of taxes or receipt of tax benefits. Let’s consider the following scenario as an example:

In a $1,000 taxable account:

(Gain of $100) – ($25 capital gains tax) = $75 of after-tax profits. Or a 7.5% after-tax return.

In a $1,000 non-taxable account:

(Gain of $100) – ($0 capital gains tax) = $100 after-tax profits. Or a 10% after-tax return.

It is also essential for candidates to understand that capital losses work the same way as capital gains to dampen portfolio volatility. Consider a similar example to the previous one in which the payment of taxes lowered after-tax volatility in a taxable account. This example will show how the taxable account will suffer less after-tax volatility.

In a $1,000 taxable account:

(Loss of $100) + ($25 capital gains credit) = -$75 after-tax loss. Or a -7.5% after-tax return.

In a $1,000 non-taxable account:

(Loss of $100) – ($0 capital gains tax) = -$100 of after-tax loss. Or a -10% after-tax return.

Tax-advantaged accounts generally experience lower volatility and a narrower range of returns than taxable accounts. In a taxable account, gains tend to be reduced by taxes, pulling the returns toward zero. Similarly, losses in a taxable account are somewhat mitigated by tax benefits, which can limit the negative impact on returns.

Unrealized Gains and Losses

When assets generate a capital gain, a tax liability arises, which becomes due when the gain is realized through a sale. Conversely, assets that incur a capital loss create an unrealized tax asset. Portfolio managers can appropriately use the money concept’s time value to account for embedded capital gains and losses. By doing so, they can accurately assess the portfolio’s after-tax volatility and return metrics. This adjustment helps to reflect the true impact of taxes on the portfolio’s performance.

Asset Location

In addition to determining the asset allocation for an investor’s total wealth, the asset location decision is also important. The concept of asset allocation is straightforward. While investors generally want exposure to different asset classes in their overall portfolio, deciding which account to allocate each asset to is not easy. Asset location follows a simple rule:

• Tax-efficient investments should be placed in taxable accounts.
• Less tax-efficient investments should be placed in tax-advantaged accounts.

Investors should avoid overloading their tax-efficient accounts with investments that are already tax-efficient. Instead, the tax advantages of these accounts should be preserved and utilized for investments that typically have higher tax liabilities. While tax regulations may vary across countries, candidates and financial professionals can refer to a list of commonalities as a starting point to determine the tax efficiency of specific investments. Further research should be conducted to assess whether an investment is more or less tax-efficient in a particular jurisdiction.

Portfolio Rebalancing

Most investors must adjust their portfolios’ asset allocations periodically to align with their initial plans outlined in the Investment Policy Statement (IPS). Over time, the returns of different asset classes may gradually cause the higher-risk and higher-return assets to become more prominent in the portfolio. To rebalance and remain within the predetermined range, these assets must be “trimmed.” However, it is essential to note that selling assets in a taxable account will have tax implications. Investors should bear the following formula in mind:

$$ \text{After-tax rebalancing range} = \frac {\text{Pre-tax rebalancing range}}{1 – \text{tax rate}} $$

Which can be formulated as follows:

$$ R_{at}=\frac {R_{pt}}{(1-t)} $$

Let’s take an example to illustrate this point. A pre-tax deviation range of 10% would be equivalent to a 14.29% after-tax deviation when considering a tax rate of 30%. Investors and analysts must consider after-tax metrics as they provide a reliable basis for comparing accounts with different tax treatments. Keeping this in mind ensures a proper assessment of the impact of taxes on investment performance.

Reducing Tax Impact

Tax-loss harvesting involves intentionally selling investments at a loss to offset capital gains in other areas of the portfolio. Although the total taxes paid remain the same, tax-loss harvesting benefits investors by deferring the payment of taxes, which brings a time value of money advantage. When taxes are paid in the future, their impact on purchasing power is reduced compared to paying the same amount today. This strategy allows investors to maximize the value of their investments over time.

Strategic asset location involves placing assets in accounts that provide advantageous tax treatment. Less tax-efficient assets are allocated to tax-exempt or tax-deferred accounts, while tax-efficient assets with low tax rates and deferred capital gains are placed in taxable accounts. Equities and high-turnover trading strategies are assigned to tax-exempt and tax-deferred accounts. However, bonds are often placed in taxable accounts when they are intended for near-term liquidity requirements. This approach helps optimize the tax efficiency of the overall investment portfolio.

Combining assets from various accounts with varying tax treatment involves adjusting the asset values used for portfolio optimization. Assets in tax-exempt accounts don’t need tax adjustments to their market values. Meanwhile, assets in tax-deferred accounts grow without taxes until distribution, linking the tax burden to their economic value since they can’t be distributed without incurring taxes. Therefore, the after-tax value of assets in a tax-deferred account is determined by the following Equation:

$$ V_{at}=\frac {V_{pt}}{(1-t_i)} $$

Where:

\(V_{at}\)= The after-tax value of assets.

\(V_{pt}\)= The pre-tax market value of assets.

\(t_i\)= The expected income tax rate upon distribution.

Question

All else equal, when compared to a taxable account, a tax-exempt account will least likely have higher:

1. Volatility.
2. Return.
3. Correlation.

Solution

The correct answer is C.

Correlations remain unchanged in the presence of taxes.

A is incorrect: The volatility of the tax-exempt account will be higher and would, therefore, be in danger of being underestimated by an unsophisticated investor.

B is incorrect: The return would depend on whether or not the returns were positive or negative. The payment of taxes would decrease positive returns in a taxable account and, therefore, lower tax-advantaged account returns. However, in the case of negative returns (losses), a taxable account will likely earn capital loss credits, improving the returns by making them less negative than non-taxable returns.

Asset Allocation: Learning Module 5: Asset Allocation with Real-World Constraints; Los 5(b) Discuss tax considerations in asset allocation and rebalancing