Tax-Adjusted Asset Allocation: Is It Necessary?

Asset allocation is one of the most important principles in investing. Investors need to strike the appropriate balance between stocks, bonds, and other asset classes.

When calculating asset allocation, some investors will adjust the value of each account by its marginal tax rate. They argue that this represents a more accurate calculation of asset allocation.

Is calculating a tax-adjusted asset allocation necessary for the typical investor?

A dollar in a Roth IRA is worth more than a dollar in a 401(k)

The central concept of tax-adjusted asset allocation is that the nominal value (the dollar amount you see at Vanguard or Fidelity) of an investment account is not equal to its after-tax (or tax-adjusted) value. Depending on the type of account, withdrawals may or may not be subjected to taxes.

To illustrate this point, here’s how to calculate the tax-adjusted account values for the most common investment accounts:

Traditional 401(k)

Since withdrawals from a 401(k) are taxed as ordinary income at the time of withdrawal, the tax-adjusted value of these investment accounts is equal to the nominal value of the account multiplied by (1 – the tax rate anticipated in retirement). The retirement tax rate is most commonly 22%, but this obviously can change with new tax laws).

For example, the tax-adjusted value of a $100,000 401(k) is $78,000 after the government takes its 22% cut on withdrawals.

Roth IRA

Since withdrawals from these accounts are not taxed after the age of 59 1/2, the tax-adjusted value of a Roth IRA is equal to its nominal value.

529s

Since withdrawals are not taxed if used for eligible educational expenses, then the tax-adjusted value of a 529 is also equal to its nominal value.

HSAs

Calculating the tax-adjusted value of these accounts are tricky. HSA money can be withdrawn tax-free if used for eligible healthcare expenses, or it can be taxed as ordinary income (like a 401(k)) if withdrawn after the age of 65.

Taxable accounts

The tax-adjusted value of taxable accounts depends on several factors. Only the profits in a taxable account get taxed, so the tax-adjusted value of a taxable account depends on its investment returns. It also depends on your long-term capital gains rate.

Calculating Your Tax-Adjusted Asset Allocation

Once you’ve determined the tax-adjustment multiplier for each of your accounts, you can then use the tax-adjusted value of your investment accounts to calculate your tax-adjusted asset allocation.

Here’s an example to illustrate how tax-adjusted asset allocation is calculated, and how it can be different from your nominal asset allocation:

Let’s say you have $100,000 each in a traditional 401(k) and a Roth IRA. You choose to invest all of your money in the 401(k) in bonds, while all of the Roth IRA money is in stocks. Your nominal asset allocation would be 50% stocks / 50% bonds. However, because you will pay 22% of the value of your 401(k) in retirement in taxes, while you will keep all of your Roth IRA money, your tax-adjusted asset allocation ends up being $78,000 in bonds and $100,000 in stocks, or 44% bonds/56% stocks.

Alternatively, if you had instead invested the $100,000 401(k) money in stocks, while invested the $100,000 Roth IRA in bonds, then your tax-adjusted allocation ends up being $78,000 in stocks and $100,000 in bonds, or 56% bonds/44% stocks.

As illustrated by this extreme example, your tax-adjusted asset allocation can differ by over 10% depending on how you allocate your investments between your various investment accounts.

Are these adjustments necessary in practice?

There are a lot of calculations that go into calculating your tax-adjusted allocation. Some of you probably even skipped the previous section. So the next logical question is whether it is even necessary to calculate tax-adjusted allocation.

While reasonable to do in theory, I don’t believe that calculating your tax-adjusted allocation or making investment changes based on these calculations are necessary, for the following reasons:

Tax laws change

Your tax-adjusted allocation will be affected by any future changes in marginal tax rates. Donald Trump and the Republicans passed a tax cut bill in 2017, lowering marginal tax rates across the board. Marginal tax rates could easily be increased again with a new president or new Congress.

The difference for most investors is not significant

While I illustrated an extreme example where the tax-adjusted asset allocation differs significantly from the nominal asset allocation, in most cases, the difference between the two will not be significant.

For example, let’s say that an investor has $100,000 in a 401(k) and $100,000 in a Roth IRA, but instead has a 90/10 stock/bond ratio. He chooses to put his 10% ($20,000) bond allocation into his 401(k) because it is less tax-efficient. Assuming a 22% marginal tax rate for the 401(k), his tax-adjusted asset allocation would be $20,000*78% / ($100,000 + $100,000 * 78%) = 8.8% bonds. This is not significantly different from his 10% nominal bond allocation.

Risk tolerance is based on fear, which is based on nominal account values

Asset allocation is all about risk tolerance. If it were about maximizing return without thinking about risk, then 100% stocks (actually > 100% stocks with leverage) would be the optimal asset allocation. However, since most investors cannot stomach large losses in their accounts, they hold some bonds in their portfolio.

The amount of bonds in your portfolio is primarily based on your risk tolerance, or how much you are willing to lose. Risk tolerance is mostly a psychological issue, and the amount you are willing to lose is based on the nominal amount of money lost in your account, not the tax-adjusted amount. If your 401(k) goes down by $100,000, most investors don’t think about how they actually only lost $78,000, since the government owns 22% of the account when it is withdrawn; they think they lost $100,000.

Additional Reading

This post was inspired by and draws many concepts from the Bogleheads wiki article on the subject. Mel Lindauer also discusses this topic in a Forbes article. Physician on FIRE has talked about the concept that a $1 in some accounts are worth more than $1 in other accounts. This forum thread on the White Coat Investor forum includes some other physicians’ opinions on tax-adjusted investing.

Conclusion

When assessing your overall asset allocation, it is reasonable to adjust the allocation based on the expected marginal tax rate of your various investment accounts. Your tax-adjusted asset allocation could potentially be different from your nominal asset allocation. However, since asset allocation is mostly based on risk tolerance, most investors probably won’t need to adjust their portfolios.

What do you think? Do you base your calculated asset allocation on the nominal values of your accounts or the tax-adjusted values of these accounts?