Faculty of Economics and Business Administration Publications Database

Asset Allocation over the Life Cycle: How much do Taxes Matter?

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Authors:
Fischer, Marcel
Munk, Claus
Source:
Volume: 37
Number: 11
Pages: 2217 - 2240
Month: November
ISSN-Print: 0165-1889
Link External Source: Online Version
Year: 2013
Keywords: Portfolio Choice; Life Cycle Asset Allocation; Taxation; Unspanned Labor Income
Abstract: 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%. That is, our work provides a justification for ignoring taxes in life cycle portfolio choice problems – a wide-spread assumption in that literature. 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.
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