Saving for retirement is a long-term financial goal. Ensuring the health of your retirement income will rely on a sound savings strategy.
All of the money you save will need a home, but what accounts are best to keep your assets safe? The answer to that is a process called asset location.
Asset location is the practice of choosing the right account (or 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
Asset location is different from asset allocation. Though the concept of location and allocation seem similar, they are quite different. Asset allocation focuses on diversification of investments for the management of portfolio risk and asset location focuses on storing investments in accounts with differing tax characteristics.
Before choosing the best home for your retirement assets, it is important to know the type of accounts available to you. Each account has its own contribution, withdraw, and tax rules. Let’s explore these options to help give you a sense of what your options are and how they can apply to your finances.
- Traditional IRA, 401(k), or deferred annuity
- Roth IRA
- Cash, bank account, high-interest savings account, brokerage account.
The primary difference between the three accounts is the time that it is subject to taxes. With a tax-deferred account like a traditional IRA, the money is not taxable until it is withdrawn. 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 rules of the account are followed). A taxable account comes with flexibility but 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 thinking about the division of assets and which ones have a better chance of increasing profit and investment margins.
Taxes are the main catalyst pushing an active asset location strategy. Now that you know how the account types are taxed, let’s take a look at how the investment options themselves are taxed.
There are many different ways to invest your assets for retirement. But each option presents its own set of tax rules and regulations, this is known as the tax efficiency level of each asset. 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. Here are some of the main assets you may be familiar with and their tax efficiency.
*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.
Bonds = inefficient
- The interest accrued is taxed at an ordinary income rate.
- Does not apply to tax-free bonds such as municipal bonds and US Saving bonds.
Individual stocks = efficient
- Most are efficient if held for at least a year.
- Capital gains on the sale of stocks held for a year are less than if the asset is sold before then.
- Your tax bracket will determine the percentage of capital gains tax.
- Qualified dividends are taxed at capital gains rates and non-qualified dividends are taxed as ordinary income.
Mutual Funds and Exchange-Traded Funds (ETF) = both efficient and inefficient
- Dependent on the management and turn-over rate of the stocks.
- Some stocks in the portfolio are subject to short-term capital gains tax.
- Volatility of being actively managed can sway the tax efficiency scale, though mutual funds often fall on the more efficient side.
- Exchange-traded funds are more efficient than mutual funds, all other things being equal.
Finding the Right Fit
We have gone over the type of accounts available, the primary investment channels, and the taxable consequences of each. Armed with this information, how do you go about putting the right assets in the right account?
The goal of asset location is to help increase your after-tax returns. There are a couple of general rules that should help guide you.
Put the most tax efficient investments in taxable accounts.
- For example, if you have municipal bonds or municipal bond mutual funds, it is a good idea to put them in a taxable brokerage account in order to increase your returns.
- Tax-managed mutual funds and managed accounts are best here.
- Low turnover stocks, stock mutual funds and stock ETFs.
Put the most tax-inefficient investments in tax-deferred or tax-exempt accounts.
- In the case of high-turnover stocks or stock mutual funds, these are best in a tax-deferred account like a 401(k) or traditional IRA.
- Real estate investment trusts.
- Fully taxable bonds and corporate bonds in tax-deferred accounts.
- Growth stocks, growth stock mutual funds and growth stock ETFs in tax-exempt accounts.
Asset location is a strategy important for pre-retirees. Once you reach retirement an optimal withdrawal order will affect the longevity of your portfolio. Knowing the ins and outs of how your accounts and investments will be taxed will help you determine the best place to keep your growing and optimize your after-tax retirement income.