Saving for retirement is a long-term financial goal. Ensuring the health of your retirement income will depend on a sound savings strategy.
Asset location is choosing the proper account (or a mix of accounts) to help you maximize your retirement savings. This process will help accomplish 3 primary tasks:
- Increase the growth of your investments
- Outline the way you will receive your retirement income
- Mitigate the tax bill on your assets
One Quick Note
While they may seem similar, asset location differs significantly from asset allocation. Asset allocation focuses on the diversification of investments to manage portfolio risk. Asset location focuses on storing investments in accounts with differing tax characteristics to get the most out of your money.
Before choosing the best home for your retirement assets, knowing the type of accounts available to you is vital. Each account has its contribution, withdrawal, and tax rules. Let’s explore these options to help give you a sense of your options and how they can apply to your finances.
As stated in its name, a tax-deferred account defers or delays your taxes. This can be very advantageous if used in the right way.
When contributing to a tax-deferred account, your initial contributions are eligible for certain tax deductions. After these have been applied, the money in the account grows until you decide to withdraw. That money will be taxed at your ordinary income rate when you withdraw.
Examples of tax-deferred accounts include a traditional IRA, a 401(k), or a deferred annuity.
A tax-exempt account doesn’t mean you’re genuinely exempt from taxes- but it does have an advantage. When you deposit into this account, you do so with money that has already been taxed. Later, your withdrawals will not be subject to taxes.
A Roth IRA is an example of a tax-exempt account. In the case of a Roth IRA, or a tax-exempt account, all contributions are taxed as income, but withdrawals are tax-free as long as the account rules are followed.
A taxable account is more of a “traditional” account that is taxed typically within the year that interest, dividends, and capital gains are earned.
Taxable accounts include cash, bank, high-interest savings, and brokerage accounts.
Remember, most interest and dividends are taxable immediately, and gains are taxable at capital gains rates when assets are sold.
Understanding how particular accounts are taxed is the first step to considering the division of assets and which ones have a better chance of increasing profit and investment margins.
Consider Your Options
As you can see, one significant difference between the three accounts is the time that it is subject to taxes. Also, with a tax-deferred or tax-exempt account, there are specific rules to abide by, whereas a taxable account comes with flexibility.
Taxes are the primary catalyst pushing an active asset location strategy. Now that you know how the account types are taxed, let’s look at how the investment options are taxed.
There are many different ways to invest your assets for retirement. Also, each option presents its own set of tax rules and regulations, known as the tax efficiency level.
As a rule of thumb, the more tax-inefficient an asset is, the more tax you will pay on it every year if it is in a taxable account. By having an idea of the tax efficiency of each type of investment, you will be able to determine which account will help that asset grow the most in its lifetime.
Finding the Right Fit
The goal of asset location is to help increase your after-tax returns. There are a couple of general rules that should guide you.
The first rule is to put the most tax-efficient investments in taxable accounts.
In other words, make your money work for you by harnessing the nature of the account to pay the lowest taxes. For example, if you have municipal bonds or municipal bond mutual funds, putting them in a taxable brokerage account is an excellent idea to increase your returns.
The second rule is to put the most tax-inefficient investments in tax-deferred or tax-exempt accounts.
Conversely to the previous rule, if you have investments that will shoulder a higher tax burden, put them in accounts where this will soften the blow a bit.
For example, if you have high-turnover stocks or stock mutual funds, these are best in a tax-deferred account like a 401(k) or traditional IRA.
Other examples include:
- Putting fully taxable bonds and corporate bonds in tax-deferred accounts.
- Growth stocks, growth stock mutual funds, and growth stock ETFs in tax-exempt accounts.
An Example of Asset Location
How might this financial strategy look with some actual numbers? Let’s take this example from Fidelity:
“Say Adrian, age 40, is thinking about diversifying his portfolio by investing $250,000 in a taxable bond fund. For this example, we will assume Adrian pays a 35.8% marginal income tax rate on net investment income and the bond fund is assumed to earn a 6% rate of return each year—before taxes. (Actual rates of return may vary.)
In what account should he hold the investment? The answer matters, and can mean the difference between paying taxes annually and deferring them until withdrawal.
Suppose Adrian has 2 accounts with sufficient assets to choose between, to hold the investment. One is his taxable brokerage account where interest earned on the investment will be taxed annually; the other is a traditional IRA he has been making after-tax contributions to for many years. Since Adrian began contributing to the IRA midway through his career, he never made any tax-deductible contributions.
If Adrian chooses to hold the investment in the tax-deferred IRA, the return on his investment, after-taxes, could be nearly $72,000 greater than it would be in the taxable account when he begins withdrawals 20 years later at age 60, assuming his tax rate remains the same.”
This is just one example of using the proper accounts to their highest benefit to get the most money out of a portfolio.
Knowing how your accounts and investments will be taxed will help you determine the best place to keep your money growing and optimize your after-tax retirement income.
Contact us and get started today to ensure your assets are located in a way that will help you live the future life you want.