Precautionary Savings Motives and Tax Efficiency of Household Portfolios: An Empirical Analysis

36 Pages Posted: 28 Jan 2005

See all articles by Gene Amromin

Gene Amromin

Federal Reserve Bank of Chicago

Date Written: January 2005

Abstract

Tax efficiency is the dominant consideration in theoretical portfolio models that allow for both taxable and tax-deferred accounts (TDAs). Investors are advised to locate higher-tax assets in their tax-deferred accounts, which in the Unites States commonly translates into holding bonds inside TDAs and holding equities outside. Yet, observed portfolio allocations are not tax efficient. This paper empirically evaluates the predictions of a recent model designed to bridge the existing gap by explicitly incorporating uninsurable labor income risk and limited accessibility of TDA assets in household decisions [Amromin, 2003]. Together, these elements create tension between household's desire to maintain tax efficient allocations and its concern over the need to make costly TDA withdrawals in the event of bad income draws. This leads some borrowing-constrained households facing labor income risk and TDA access penalties to forgo tax efficiency in favor of allocations that provide more liquidity in bad income states - an outcome labeled as precautionary portfolio choice. The empirical results based on household-level portfolio data from the Survey of Consumer Finances provide evidence that both the choice of whether to hold a tax efficient portfolio and the degree of portfolio tax inefficiency are related to the presence and severity of precautionary motives.

Keywords: Tax efficiency, precautionary motives, portfolio choice, tax-deferred retirement savings

JEL Classification: D12, G11, H24

Suggested Citation

Amromin, Gene, Precautionary Savings Motives and Tax Efficiency of Household Portfolios: An Empirical Analysis (January 2005). FEDS Working Paper No. 2005-01. Available at SSRN: https://ssrn.com/abstract=656012 or http://dx.doi.org/10.2139/ssrn.656012

Gene Amromin (Contact Author)

Federal Reserve Bank of Chicago ( email )

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