RFS Advance Access originally published online on June 27, 2008
Review of Financial Studies 2008 21(5):2173-2207; doi:10.1093/rfs/hhn064
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Taxable and Tax-Deferred Investing: A Tax-Arbitrage Approach
University of Texas at Austin
Address correspondence to Jennifer Huang, McCombs School of Business, University of Texas at Austin, Austin, TX 78712; telephone: (512) 232-9375; fax: (512) 471-5073; e-mail: jennifer.huang{at}mccombs.utexas.edu.
JEL Classification: G11
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Abstract |
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We analyze an intertemporal portfolio problem with both taxable and tax-deferred retirement accounts. Using a tax-arbitrage argument, we identify conditions under which the optimal location decision (where to place an asset) is separable from the allocation decision (how much to allocate to each asset). Investors place highly taxed assets in the tax-deferred account to maximize the tax benefit and adjust their taxable portfolios to achieve the optimal risk exposure. We show that the two-account problem can be reduced to a taxable-account-only problem. The results are robust to capital gains tax deferrals, consumption and contribution decisions, and stochastic tax rates.
This paper is based on my dissertation at the Massachusetts Institute of Technology. I thank my advisors John Cox, Stephen Ross, and especially Jiang Wang for advice and encouragement. I am grateful for comments from Robert McDonald (the editor), an anonymous referee, Kenneth French, Lorenzo Garlappi, Robert Jarrow, Pete Kyle, Francis Longstaff, Jim Poterba, Laura Starks, Jeremy Stein, Sheridan Titman, and seminar participants at the Asset Location Conference at Stanford, Boston College, Cornell, Duke, MIT, New York University, Ohio State University, Penn State University, Stanford, University of British Columbia, University of Chicago, University of North Carolina, University of South California, University of Texas at Austin, and Yale. Brenda Priebe provided excellent editorial support.