Asset Allocation Over the Life Cycle: How Much Do Taxes Matter?
54 Pages Posted: 26 Sep 2010 Last revised: 17 May 2013
Date Written: January 21, 2012
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%. 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
JEL Classification: G11, H24
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