Tax-Cognizant Portfolio Analysis: A Methodology for Maximizing After-Tax Wealth

Kenneth A. Blay and Harry M. Markowitz

Volume 14, Number 1, 2016

The most prevalent methods of incorporating taxes into the portfolio construction process are the preliminary adjustment of asset allocation inputs for taxes and the post-optimization application of asset location heuristics. We argue that these methods are unsatisfactory in that they fail to address taxation dynamics that result from investment and consumption-dependent illiquidities. Tax-Cognizant Portfolio Analysis (TCPA) is proposed as a methodology that addresses these issues while seeking to maximize expected after-tax wealth for given levels of risk. TCPA achieves this through the use of simulation methods to assess the impact of portfolio turnover, sequence of investment returns, and wealth consumption decisions on after-tax wealth outcomes from taxable, tax-deferred, and tax-exempt accounts.