The Effect of Income Taxes on Optimal Portfolio Selection

The ability to shelter both the periodic contribution and annual returns from income taxes in a qualified retirement plan provides well known advantages. However, given aggressive investing and a continuation of historic rates of return on financial assets, it is probable that both income during the retirement years and the effective tax rate will be higher than in the working years. Consequently, part of the additional expected return to taking greater risk is lost to taxes. This paper demonstrates that efficient (i.e., utility-maximizing) portfolio design must 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. In generally, failure to consider progressive taxes will result in portfolio being overinvested in the high-risk asset.