Are stocks desirable in tax-deferred accounts? Garlappi, Lorenzo; Huang, Jennifer

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Garlappi, Lorenzo ; Huang, Jennifer
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The Journal of Public Economics
Risk aversion -- Analysis; Retirement income -- Management; Tax-free exchanges -- Forecasts and trends
Academic; Trade
To link to full-text access for this article, visit this link: Byline: Lorenzo Garlappi, Jennifer Huang Keywords: Portfolio selection; Tax-deferred accounts; Borrowing and short-selling constraints Abstract: Existing literature suggests that, in order to maximize the tax benefit of retirement accounts, investors should follow a "pecking order" location rule of placing highly taxed assets (e.g., bonds) in a tax-deferred account and lightly taxed assets (e.g., stocks) in a taxable account. Empirical evidence, however, documents that a large number of investors violate this rule. In this paper, we show that such violations can be optimal for risk-averse investors who face portfolio constraints. In particular, while the strategy of placing bonds in the tax-deferred account maximizes the expected level of tax benefit, it may lead to volatile benefits under different realizations of stock returns. By holding a similar portfolio in both accounts, investors can achieve a more balanced growth in the two accounts, minimize the likelihood of violating the constraints in the future and hence "smooth" the volatility of the tax benefit. For some risk-averse investors, this smoothing motive can lead to the observed violation of the pecking order location rule. Our model predicts that such violations are more likely when future tax benefits are more volatile, which can occur, for example, when: (i) the tax rate differential across assets increases over time due either to tax law changes or to tax bracket changes for investors; (ii) asset returns are more volatile; and (iii) investors anticipate large future liquidity needs. Author Affiliation: McCombs School of Business, B6600, The University of Texas at Austin, Austin TX, 78712, United States Article History: Received 23 October 2004; Revised 3 April 2006; Accepted 21 April 2006 Article Note: (footnote) [star] We are grateful to Bob Dammon, Jim Poterba (the editor), Laura Starks, Sheridan Titman, Raman Uppal, Jiang Wang, Tan Wang, Roberto Wessels, three anonymous referees, and seminar participants at the University of Texas at Austin and the 2004 WFA Meetings for helpful comments and suggestions. All errors are our own. A previous version of this paper circulated under the title "From location to allocation: Taxable and tax-deferred investing with portfolio constraints."
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