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290 Deciding how much of a portfolio to allocate to different types of assets is one of the fundamental issues in financial economics. For taxable individual investors, the proliferation of tax-deferred vehicles for retirement saving, such as individual retirement accounts (IRAs), 401(k) plans, Keogh plans, and 403(b) plans, has added a new dimension to the historical asset allocation problem . A taxable investor needs to make choices not just about the amount to hold in various assets but also about where to hold those assets. If there are two asset classes, broadly defined as riskless and risky, the asset allocation problem facing tax-exempt investors involves choosing only the fraction of the portfolio to allocate to the risky asset. Taxable investors with a tax-deferred retirement saving account, however, face a more complex problem, since they must decide how much of the risky asset to hold in their tax-deferred account and how much to hold in their taxable account. Shoven (1999), Shoven and Sialm (2004), and Dammon, Spatt, and Zhang (2004) labeled the problem of deciding where to hold a given asset the asset location decision. Poterba, Venti, and Wise (2000) have shown that more than 30 million workers currently participate in 401(k) pension plans; millions more have taxAsset Location for Retirement Savers james m. poterba, john b. shoven, and clemens sialm 10 We thank Olivia Lau and Svetla Tzenova for assistance with data collection and William Gale, Davide Lombardo, Sita Nataraj, and Paul Samuelson for helpful comments on an earlier draft. James Poterba thanks the National Science Foundation for research support. 10-0238-8 chap10.qxd 3/9/04 3:05 PM Page 290 Asset Location for Retirement Savers / Poterba, Shoven, and Sialm 291 deferred assets in IRAs. Virtually all 401(k) plans—and all IRAs—give account holders substantial discretion in choosing the set of assets that they hold. Therefore most account holders who also have other assets outside the tax-deferred accounts face asset location choices. The choices are likely to be most salient for middle- and upper-middle-income households whose tax-deferred assets represent a substantial fraction, but not all, of their financial wealth. Recent legislation prospectively increasing the limits on contributions to tax-deferred retirement saving plans could make the asset location decision more significant for households in higher income and wealth strata, since the legislation will increase the total pool of assets that a household can accumulate in a taxdeferred setting. How holding an asset in a taxable or tax-deferred account affects long-term wealth accumulation depends on the tax treatment of the asset in question as well as on the other assets available. Given a set of assets that an investor wishes to hold, long-run wealth accumulation generally will be maximized by placing the most heavily taxed assets in the tax-deferred account (TDA) while holding the less heavily taxed assets in the taxable account. We refer to the latter as the conventional savings account (CSA). The asset location problem is a practical question in applied financial economics that confronts many households as they save for retirement and other objectives. Yet much of the conventional wisdom on asset location for individual investors derives from research on a related problem confronting corporations . Two decades ago, Black (1980) and Tepper (1981) studied the problem of asset allocation for a corporation that could choose to hold its assets in its defined benefit pension plan or in its taxable corporate account. They explored corporate asset location problems with respect to taxable bonds and corporate equities. Taxable bonds were assumed to generate heavily taxed interest income, and corporate equities were assumed to generate lightly taxed returns because capital gains are not taxed until they are realized. The studies concluded that because bonds are taxed more heavily than stocks, a firm could maximize shareholders ’ after-tax cash flow by placing bonds in the pension account and stocks in the taxable corporate account. The pension account in the corporate setting is equivalent to an individual investor’s tax-deferred account. Something like that analysis underlies the suggestion, made by many financial advisers, that individual investors should allocate taxable bonds to their tax-deferred account before holding any such bonds in their taxable account. However, that analysis neglects two important aspects of the investment decisions that face many taxable investors. First, heavily taxed corporate or government bonds are not the only way for taxable investors to participate in the market for fixed-income securities...

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