Keywords: Tax efficiency, precautionary motives, portfolio choice, tax-deferred retirement savings
Abstract: Tax efficiency is the dominant consideration in theoretical portfolio models that allow for both
taxable and tax-deferred accounts (TDAs). Investors are advised to locate higher-tax assets in
their tax-deferred accounts, which in the Unites States commonly translates into "holding bonds
inside TDAs and holding equities outside." Yet, observed portfolio allocations are not tax efficient.
This paper empirically evaluates the predictions of a recent model designed to bridge
the existing gap by explicitly incorporating uninsurable labor income risk and limited
accessibility of TDA assets in household decisions [Amromin, 2003]. Together, these elements
create tension between household's desire to maintain tax efficient allocations and its concern
over the need to make costly TDA withdrawals in the event of bad income draws. This leads
some borrowing-constrained households facing labor income risk and TDA access penalties to
forgo tax efficiency in favor of allocations that provide more liquidity in bad income states--an
outcome labeled as "precautionary portfolio choice." The empirical results based on household-level
portfolio data from the Survey of Consumer Finances provide evidence that both the choice
of whether to hold a tax efficient portfolio and the degree of portfolio tax inefficiency are related
to the presence and severity of precautionary motives.
Full paper (343 KB PDF)
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Last update: January 5, 2005