Effective Tax Rates

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.

Two Methods of Tax Rate Inputs

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.

Effective Tax Rate Worksheet

Effective Tax Rate Worksheet

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

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 $\upsilon$.

Estimated Effective Tax Rates

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.

Specify your own tax rates

How Are Tax Rates Applied?

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 Estimates in the global ribbon bar.

Applying tax estimates to asset classes

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

Asset Allocation in Taxable PortfoliosWindham Insights

Application of Effective Tax Rates in Asset Allocation

References

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