Using tax rates on asset classes in the Windham Portfolio Advisor

The Windham Portfolio Advisor provides a module to help estimate effective tax rates across asset classes. The program allows the analyst to include their own proprietary estimates of effective tax rates.

Taxable investors should use after-tax returns and risks as inputs to a Markowitz portfolio construction analysis [Wilcox et. al. 2006]. Tax-advantaged accounts, such as pension plans and other retirement accounts, may be treated as different asset classes.

$\tau_n=(O_n \times \Phi_n)+(O_n \times \psi_n)+(Q \times \delta_n) + (\gamma \times \upsilon_n)$

The worksheet in the Windham Portfolio Advisor calculates the effective tax rates$\tau_n$ for each asset $n$, as a function of ordinary income $O$, federal tax rates $\Phi$, state tax rates $\psi$, qualified dividends tax rates $Q$, qualified dividends $\delta$, the long-term capital gains tax rate $\gamma$, and unrealized capital gains $\upsilon$.

The estimated effective tax rates selection allow the analyst to specify proprietary estimates of effective tax rates across asset classes by editing the grid column, or by importing a vector of numbers from the clipboard / Excel.

The effective tax rates are applied to expected risk and return estimates across asset classes as specified by the user. To use after-tax estimates, check the *After-Tax Estimate*s in the global ribbon bar.

Effective tax rates specified on the *Define Taxes* screen are applied to the expected returns $E[R]$ and risk $E[\sigma]$ of each asset class by discounting its pre-tax estimates:

$E[\hat{R}]_n=(1-\tau_n) E[R]_n$

$E[\hat{\sigma}]_n=(1-\tau_n) E[\sigma]_n$

Subsequently, the after-tax estimates of expected return and risk for each asset class are used for portfolio construction, summarizing portfolio statistics, estimating exposure to loss, and as simulation inputs for risk management and cash flow analysis.

For a practical application on taxes in asset allocation, please see

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Wilcox, J., Horvitz, J., and diBartolomeo, D. (2006). *Investment Management for Taxable Private Investors*. The Research Foundation of CFA Institute.