Updated: Dec 6, 2021
Asset Location: A Tax Lens on Retirement Investing
As our real estate friends say, location matters. It also matters with investing as to what types of accounts to hold your investments in - including in your retirement.
You've built your retirement nest egg, but eventually you will need to take income from it.
This is why once you’re in retirement, your focus shifts a bit. The difference in how accounts are taxed becomes apparent when you start withdrawing money. Also, how the investment itself is taxed - be it a mutual fund, common stock or ETF, can make a difference to the overall return of the portfolio over time, and the amount of taxable income generated each year. When you take income from your portfolio, a tax efficient strategy keeps more money in your pocket and more money invested. Over a multi-decade retirement, this can make a big difference. Also, since your income determines how much of your social security benefits are taxable and whether a premium on Medicare Part B is due, it’s essential to keep your taxable income down.
Asset location is a retirement strategy that prioritizes the accounts you hold your investments in: tax-free, tax-deferred, and taxable accounts - to maximize after-tax returns. This mixture of accounts gives you flexible income because each account has different tax treatments. So while one account may have required minimum distributions, increasing your taxable income, another account may not. Finding a proper balance of tax-efficiency is the idea of asset location.
The Different Investment Accounts
Tax-deferred accounts include 401(k)s, Traditional IRAs, and 403(b)s. You contribute pre-tax dollars, which lowers your taxable income in the contribution year. Earnings grow tax-deferred (you put Uncle Sam on hold). Tax-deferred accounts typically have required minimum distributions (RMDs) at age 72. Taxes are due when withdrawals are made.
Tax-free accounts include Roth IRAs and Roth 401(k)s. You contribute after-tax dollars, so you get no tax deduction. But the money grows tax-free and can be withdrawn entirely tax-free at retirement if all qualifications are met.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. If you make too much income to contribute to a Roth IRA, a Roth conversion can allow higher earners to benefit (alert: conversions are under the microscope with new tax proposals).
Taxable accounts are brokerage accounts with no tax benefits when contributing or withdrawing. Investments are taxed when sold or when they pay dividends or interest. The nice thing about taxable accounts is that you can withdraw funds anytime without worrying about early withdrawal penalties. Investments in taxable accounts can get preferential capital gains treatment depending on how long the investment was held, and dividends may get favorable tax treatment. Taxable accounts are not subject to RMDs, 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, you can choose which assets belong where. Basically, you’re pulling two levers, tax-efficiency and returns. If an investment is tax-efficient, it can go into a taxable account. If an investment isn’t tax-efficient, it can be offset with a tax-efficient account. 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 (typically bonds - when they pay interest that is) would belong in a Roth IRA or 401(k).
However, since the taxes you will owe depends on the growth of the investment, it can make sense to categorize investments by their return potential. Just ask Peter Thiel of PayPal. He turned $2000 into $5 Billion in his Roth IRA!
Asset location can be complicated, but the tax benefits are worth it. Building a tax-efficient retirement strategy is challenging, you can become a part-time CPA and do this on your own, or go golf and let me do it for you.
Contact me if you need help! John Piershale, CFP®, AEP®
John Piershale Wealth Management, LLC is an Investment Adviser registered with the State of IL and in other jurisdictions where exempt from registration. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned.
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