Asset Location is a powerful tool to minimize taxes across different investment accounts. It refers to the strategic placement of different investments in your total portfolio across different account types, such as taxable brokerage accounts, IRAs, and 401(k)s, to take advantage of each account’s tax benefits.
Not to be confused with asset allocation, asset location focuses on what specific accounts to place your investments in; while asset allocation is the process of of putting together a diversified set of investments (such as stocks, bonds, cash, etc) that fits your needs. Asset Allocation should happen before asset location.
Today, I will explain how asset location plays a critical role in reducing taxes during retirement, maximizing your wealth, and preserving more of your hard-earned savings.
Understanding Asset Location Basics
To truly grasp the significance of asset location, first, you need to understand the different types of account types and how each account type is taxed.
Here’s a quick rundown:
Taxable - Brokerage Accounts:
Contribution: After-tax.
Income and growth: Income (such as dividends and interests) is taxed as it is generated. Investment growth is not taxed until withdrawal.
Withdraw: subject to capital gains taxes on investments sold for a profit. Based on how long you hold the assets, it can be subject to Short Term Capital Gain (STCG) tax or Long Term Capital Gain (LTCG) tax.
Pre-tax accounts - Traditional IRAs and 401(k)s:
Contribution: Not taxed on.
Income and growth: These accounts provide tax-deferred growth, meaning you don’t pay taxes on the earnings until you begin withdrawals in retirement. As long as the investments stays in the account, it's not taxed. This applies to dividends and interests generated by investments also.
Withdraw: Withdraw after you turn 59 1/2 (qualified withdrawals) will be subject to income tax. Unqualified withdrawals will be subject to penalty in addition to income tax.
SPECIAL CONSIDERATION: Required Minimum Distributions (RMDs) kick in at age 73, forcing you to withdraw and pay taxes on the money at your ordinary income tax rate.
Tax-free accounts - Roth IRAs/ 401(k)s:
Contribution: After-tax income.
Income and growth: Income and growth are generally tax-free.
Withdraw: Like the name suggests, as long as your withdrawals are qualified. You don't need to pay taxes.
The differences in tax treatment give us great opportunities to optimize our investment placement based on their characteristics.
Overall Guidelines for Asset Location Strategies
Now that we understand how various account types are taxed; let’s explore how to implement asset location strategies to minimize taxes in these accounts:
Placing Tax-Efficient Investments in Taxable Accounts:
Since taxes occur when we buy and sell, we want to place more tax-efficient investments like exchange-traded funds (ETFs) in taxable accounts while minimizing investments that trade, therefore incurring capital gain taxes, too often. On the other hand, since tax for income in taxable accounts occurs when it's generated, (as opposed to withdrawal in pre-tax accounts), we want to minimize investments that generate too much income on an ongoing basis, such as high dividend stocks, high interests bonds and REITs.
Holding Income-Producing and/or Lower Growth Investments in Tax-Deferred Accounts:
Income-producing investments such as bonds, REITs, and dividend-paying stocks are better placed in tax-deferred accounts like traditional IRAs and 401(k)s. Since there's no tax event unless you take money out of pre-tax, you can trade all you want and have all of the income generated. As long as you don't take money out, you won't be taxed.
Since we ultimately still need to pay tax on withdraws, and RMDs are imposed on pre-tax accounts such as 401(k)s and IRAs, it's smart to place a lower growth portion of your diversified portfolio in your pre-tax account when available. That way, we can minimize tax in retirement when we make inevitable withdraws.
Placing High Growth Assets in Tax-Free Accounts (such as Roth IRAs and Roth 401(k)s):
High-growth assets, such as stocks or equity mutual funds, should ideally be placed in Roth IRAs. Since Roth IRAs grow tax-free and qualified withdrawals are also tax-free, this account is perfect for long-term growth investments. Since we don't need to pay taxes on qualified withdraws, we can let our investments in Roth accounts grow as much as they can and not have to worry about higher income tax on these investments.
The Benefits of Proper Asset Location in Retirement
Proper asset location has several tax-saving benefits that will work in your favor during retirement:
Lowering Overall Taxable Income:
By strategically placing income-generating assets in tax-deferred accounts, you reduce your taxable income during retirement, which may help lower your overall tax bill.
Maximizing Roth IRA Withdrawals:
By placing growth-oriented investments in your Roth IRA, you can take full advantage of tax-free withdrawals. This strategy not only helps you avoid paying taxes on your investment gains but also gives you more control over your taxable income in retirement.
Reducing the Impact of RMDs:
RMDs are mandatory in traditional IRAs and 401(k)s. By shifting more growth-focused assets into Roth IRAs, you can minimize the impact of these distributions, keeping more of your funds growing tax-free for longer.
Ongoing Maintenance of Your Asset Location
Asset location isn’t a static decision; it’s a strategy that should evolve with your financial situation. Asset location can be a great tax savings too, but it also requires more time to maintain. Here are some typical points to consider for ongoing maintenance of your asset location plan:
Ongoing Rebalancing:
Rebalancing of your investments is generally recommended on an annual basis. Rebalancing is the process of adjusting the weights of assets in a portfolio to maintain the desired allocation, ensuring it aligns with an investor's risk tolerance and long-term goals. When you rebalance your account, it's vital to manage the taxable brokerage accounts in a tax-aware way so you don't encounter too much capital gain tax.
Changing Asset Allocation:
Our desired asset allocation in our 20s might not suit our life in our 50s. That's why it's also important to adjust your asset allocation with changing priorities. Since asset allocation happens before asset location, it's important to re-evaluate your asset location once your allocation changes.
Consult a Financial Planner:
Navigating asset location can be complex, and a financial planner can help you create and adjust a strategy that’s tailored to your goals.
Conclusion
Asset location is an advanced tool in tax-efficient retirement planning. By understanding how different assets are taxed in various accounts, you can strategically position your investments to minimize your tax burden throughout your lifetime.
Whether you’re in the accumulation phase or approaching retirement, optimizing your asset location can help you keep more of your hard-earned savings. Be sure to revisit your strategy periodically, and consider working with a financial planner to ensure you’re making the most of the tax advantages available to you.
Disclosure:
All written content on this site is for informational purposes only.Opinions expresses herein are solely those of Savor Financial, a Core Planning brand.All information and ideas should be discussed in detail with your individual advisor prior to implementation. Investment advisory services are offered through Core Planning, LLC.The presence of this website on the internet shall in no direct or indirect way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services.The information contained here is general in nature and is not intended as legal, tax, or investment advice. Further, the information contained herein may not be applicable to, or suitable for, the individuals’ specific circumstances or needs and may require consideration of other matters.CP does not provide legal advice or drafting services. Estate planning is considered incidental within the context of a financial plan. We will coordinate with your family attorney of choice. CP is not a certified public accountant and does not provide tax filing services. Tax related advising is considered incidental within the context of a financial plan. We will coordinate with your CPA of choice.
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