The Effect of Income Taxes on Optimal Portfolio Selection

Abstract

The ability to defer federal and state income taxes on both the periodic contribution and annual returns in a qualified retirement plan provides a well-known and powerful wealth accumulation tool. Given aggressive investing in these plans and a continuation of historic rates of return on financial assets, some investors will find that both income during the retirement years and the effective marginal tax rate will be higher than in the working years. Consequently, part of the additional expected return to taking greater risk would be lost to taxes. This article demonstrates that efficient (i.e., utility-maximizing) portfolio design should account for the potential for higher average and marginal income tax rates in retirement. Failure to fully consider the ultimate tax effects probably will result in a suboptimal portfolio of assets during both the accumulation and distribution phases. Essentially, assets may be invested with less risk and yet achieve the same or even higher levels of economic welfare. In general, failure to consider progressive taxes will tend to result in a portfolio being overinvested in higher-risk assets such as common stock.