Asset location can be a complex strategy to implement. But the tax benefits it can provide far outweigh the complexity. Having a fiduciary advisor to guide you may be key.
You’ve built a retirement nest egg by saving consistently and investing carefully. An asset allocation that allowed growth but gradually reduced risk as you got closer to retirement was probably part of the plan. But once you’re in retirement, your focus shifts a bit. The value of having accounts with differing tax statuses becomes apparent when you set out to create an income stream and start withdrawing money. The return profile of the asset and how it is taxed can make a great deal of difference to both the overall return of the portfolio over time, and the amount of taxable income generated each year. You’ll be dependent on the income generated by your portfolio, so any strategy that minimizes taxes keeps more money in your pocket and allows you to leave more money invested. Over a multi-decade retirement, this can make a big difference. And since income levels govern how much of social security benefits are taxable and whether a premium on Medicare Part B is due, it’s essential to keep your taxable income down as well.
Asset location is a retirement strategy that prioritizes investing in a combination of tax-free, tax-deferred, and taxable accounts to maximize after-tax returns. This mixture of accounts helps create a flexible income stream because each account has different tax treatments. So while one account may have required minimum distributions that could increase your taxable income, another account may not - and finding this balance between tax-efficiency is the core principle of asset location.
The Different Investment Accounts
Tax-Deferred
Tax-deferred accounts include 401(k)s, Traditional IRAs, and 403(b)s. These accounts allow you to contribute pre-tax dollars, which lowers taxable income in the contribution year. Earnings in these accounts grow tax-free, meaning you can buy and sell without tax impact. Also, dividends and interest earned within tax-deferred accounts are not taxable in the current year if reinvested. Taxes are due when withdrawals begin in retirement. Tax-deferred accounts typically have required minimum distributions (RMDs).
Tax-Free
Tax-free accounts include Roth IRAs and Roth 401(k)s. Contributions are made after-tax, so you don’t receive tax deductions when contributing as you do with tax-deferred accounts. The money grows tax-free and can be withdrawn entirely tax-free at retirement if all qualifications are met. Roth IRAs are not subject to RMDs. While the income limits to contribute to a Roth IRA are fairly low, a Roth conversion can allow higher earners to benefit from the advantages.
Taxable
Taxable accounts are brokerage accounts that don’t provide tax benefits when contributing or withdrawing. Investments are taxed when they are sold, traded, or generate income such as dividends or interest. The nice thing about taxable accounts is that you can withdraw funds at any time without worrying about early withdrawal penalties. Regarding taxes, investments in taxable accounts receive preferential capital gains treatment depending on how long the investment was held, and dividends are generally taxed as ordinary income. Taxable accounts are not subject to RMDs, and so they play an important role in a retirement income plan.
Matching the Asset to the Account
Now that we know the different locations available, it’s time to choose which assets belong where. When determining this, two things to keep in mind are the tax efficiency of the investment and the potential returns. The tax aspect aims to minimize taxes by strategically placing certain investments in certain accounts, playing to their tax strengths. For example, ETFs tend to be more tax-efficient than other types of investments, so these would generally belong in a taxable account. The least tax-efficient investments, such as those that will incur short-term capital gains taxes, would belong in a Roth IRA or 401(k).
Basically, you’re pulling two levers, tax-efficiency and returns. If an investment is tax-efficient, it can go into an account that will incur taxes because it has a built-in tax benefit. If an investment isn’t tax-efficient, it needs to be offset with a tax-efficient account.
Regarding the potential returns, the growth of an investment dictates how much you’ll owe in taxes. With this, it can make sense to also categorize investments by their return potential. Using this logic, high-growth assets such as small-cap stocks may be best suited for a tax-efficient account, such as a Roth IRA, so the investment can grow tax-free and avoid capital gains tax. Higher growth assets that have low tax liabilities could go into a taxable brokerage account.
The Takeaway
Asset location can be a complex strategy to implement. But the tax benefits it can provide far outweigh the complexity. When you have a tax-efficient portfolio, you get to keep more money in your pocket come tax time. Building a tax-efficient retirement strategy can be challenging, and a fiduciary wealth advisor can help determine the best tax moves to make for your situation.
IMPORTANT DISCLOSURES
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The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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Basepoint Wealth, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.