periodic distributions of realized gains. Entity Let us now assume that the index fund is held within a 401(k) or similar tax-advantaged entity. In this case, all forms of return including income, realized gains, and unrealized gains are allowed to compound on a tax-deferred basis. Eventually the investor will begin to withdraw from the account and the withdrawals will be subject to ordinary income tax. This is true regardless of the nature of the returns within the account. Generally funds will be withdrawn gradually over a period of many years. To simplify the calculation and allow a comparison to the preceding examples, we will assume a lump-sum withdrawal at the end of the holding period. We will also net out the tax benefit derived from making a pretax salary contribution to the retirement account. We are interested only in the impact of deferral on investment returns after the money is deposited into the account. Expected after-tax return = {[(1 + R)Y (1 - T) + T\<-inr>} - 1 where R = Expected total return Y = Holding period in years T = Tax rate The longer the holding period, the greater the value derived from pretax compounding. 5 years {[(1 + 10%)5 (1 - 40%) + 40%]<1/5'} - 1 = 6.44% 10 years {[(1 + 10%)10 (1 - 40%) + 40%](1/10>} - 1 = 6.94% 25 years {[(1 + 10%)25 (1 - 40%) + 40%]<lfl5>} - 1 = 8.03% The after-tax expected return is very low for short holding periods because the conversion of appreciation to ordinary income drives the tax rate toward 40 percent Table 29.3 shows the expected after-tax returns for various asset classes in differing situations based on assumptions regarding expected returns and the composition of the returns. The expected after-tax returns are a function of the pretax returns and composition of returns as described at the top of the table. The results will change as these assumptions change. What will not change is that the conversion of an expected pretax return to an expected after-tax return will vary greatly based on horizon, disposal plans, and entity. Asset allocation plans should be based on these specific after-tax returns rather than a generic after-tax return based on full and immediate taxability. Asset allocation analysis should be integrated with asset location analysis. Many wealthy individuals have complex estate structures that may include entities such as charitable remainder trusts, grantor trusts, foundations, insurance policies, and so on. Each of these entities will have unique income, transfer, and estate tax characteristics. Optimally locating the components of an asset allocation plan among these entities can significantly increase the after-tax wealth received by future heirs and charities. Asset location is another of the free