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Asset allocation over the life cycle: How much do taxes matter?

  • Fischer, Marcel
  • Kraft, Holger
  • Munk, Claus

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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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 37 (2013)
Issue (Month): 11 ()
Pages: 2217-2240

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Handle: RePEc:eee:dyncon:v:37:y:2013:i:11:p:2217-2240
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

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