From Location to Allocation: Taxable and Tax-Deferred Investing with Portfolio Constraints

Abstract

Academic literature and popular advice in general agree on the fact that investors who have access to both a taxable and a tax-deferred account should follow a "pecking order" location rule of preferring highly taxed assets in a tax-deferred account. There is however little guidance regarding how investors should adjust their overall portfolio allocation for the presence of tax-deferred accounts, especially when they face such frictions as borrowing and short-selling constraints. In this paper we first derive conditions under which the pecking-order location rule holds and then show that, for investors who follow this rule and face portfolio constraints, the optimal allocation in the two-account problem can be obtained by solving for the allocation in each account separately while treating the portfolio holdings in the other account as a "non-tradable" asset. After deriving this result for the case of a riskless bond and a risky stock, we generalize the optimal two-account allocation rules to the case of multiple assets.

Keywords: Portfolio selection, tax-deferred accounts, borrowing and short-selling constraints

JEL Classification: G11