The calculation of after-tax asset allocation is key to determining asset location, which can significantly impact an investor’s after-tax returns according to a paper by William Reichenstein, Ph.D., CFA (a copy is here as well). While this paper doesn’t mention the term “tax alpha” explicitly, it discusses some interesting tax management issues. I have experience with developing technology and product strategy around managed accounts, so the author’s advocacy of after-tax allocation peaked my interest.
What the paper states is that funds going into a tax-deferred account, like a 401(k), should be adjusted by multiplying the amount by (1 – tn), where tn is the expected tax return in retirement. So if you expect to be in the 25% tax bracket when you retire (assuming there is such a low bracket by the time you actually get to retire) you would multiply the pre-tax funds by 75% (1 – 25%) to account for future taxes.
So, if you had $2,000 to invest between a tax-deferred and taxable account, putting $1,000 into each account would not be an equal allocation using this method. You would need to put somewhere around $1,140 into the tax deferred, which would be the same as $858 after-tax. I know this doesn’t quite add up to $2,000, but I think this calculation would require a bi-nomial solution and I don’t have time to figure that out. You get the idea anyway, I’m sure.