Are Stocks Desirable in Tax-Deferred Accounts?

38 Pages Posted: 30 Aug 2006

See all articles by Lorenzo Garlappi

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business

Jennifer C. Huang

University of Texas at Austin - Department of Finance

Abstract

Existing literature suggests that, in order to maximize the tax benefit of retirement accounts, investors should follow a "pecking order" location rule of placing highly taxed assets (e.g., bonds) in a tax-deferred account and lightly taxed assets (e.g., stocks) in a taxable account. Empirical evidence, however, documents that a large number of investors violate this rule. In this paper, we show that such violations can be optimal for risk-averse investors who face portfolio constraints. In particular, while the strategy of placing bonds in the tax-deferred account maximizes the expected level of tax benefit, it may lead to volatile benefits under different realizations of stock returns. By holding a similar portfolio in both accounts, investors can achieve amore balanced growth in the two accounts, minimize the likelihood of violating the constraints in the future, and hence "smooth" the volatility of the tax benefit. For some risk-averse investors, this smoothing motive can lead to the observed violation of the pecking order location rule. Our model predicts that such violations are more likely when future tax benefits are more volatile, which can occur, for example, when: (i) the tax rate differential across assets increases over time due either to tax law changes or to tax bracket changes for investors; (ii) asset returns are more volatile; and (iii) investors anticipate large future liquidity needs.

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

JEL Classification: G11

Suggested Citation

Garlappi, Lorenzo and Huang, Jennifer Chunyan, Are Stocks Desirable in Tax-Deferred Accounts?. Journal of Public Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=927362

Lorenzo Garlappi

University of British Columbia (UBC) - Sauder School of Business ( email )

2053 Main Mall
Vancouver, BC V6T 1Z2
Canada

Jennifer Chunyan Huang (Contact Author)

University of Texas at Austin - Department of Finance ( email )

McCombs School of Business, B6600
Austin, TX 78712
United States
512-232-9375 (Phone)
512-471-5073 (Fax)

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