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[Video] Limit Tax Liability in Retirement with Asset Location
Aside from sequence of investment returns, taxes are probably the most significant factor in determining how much money you will have to spend in retirement or to leave to heirs.
As my current clients and long-time email or podcast subscribers know, we spend a good deal of time limiting lifetime tax liability for our clients.
Asset location is one tool we use at Eagle Ridge Wealth Advisors to reduce taxes or limit tax drag for our clients, but you are likely more familiar with asset allocation.
In this episode of Retire Your Way Radio, I talk about how asset location can be combined with your desired asset allocation to reduce your income taxes.
This blog post and podcast episode were originally published Apr. 6, 2022. These show notes have been updated 8/11/2023 to include additional content and a YouTube video.
Listen to Episode 43 Here:
You can listen online through the direct player above, or a much easier way to listen is by subscribing to the podcast through a free podcast app on your phone. The podcast is available on iTunes, Spotify, Google Podcasts, iHeartRadio, and several others!
So, what is the difference between asset allocation and asset location?
Asset Allocation
Asset allocation is the mix of equities, fixed income, and cash in your investment portfolio. One example is a 60/40 portfolio, which includes 60% stocks and 40% bonds.
Your asset allocation allows you to balance your risk level with the potential rewards, and this allocation will likely change over time.
Generally, if you are decades from retirement, it is beneficial to invest more of your money in equities in the stock market because you have time to ride out market downturns.
Then, as you get closer to retirement, your portfolio can become more conservative with bonds and cash to preserve the wealth you have built.
Asset Location
Asset location is positioning the investments from your asset allocation into the best accounts in order to reduce your taxable income.
You may have money invested in a taxable brokerage account, a tax-deferred retirement account, or a tax-free Roth IRA, or some combination of these accounts.
Those accounts don’t all have to have the same asset allocation mix, and they shouldn’t! However, this is how many advisors will invest for you.
This is something that gets missed all the time, and it doesn't matter if you're a DIYer or you've been working with a financial professional for years that only specializes in helping you grow your pile of money.
Many advisors still don’t focus on tax planning, and if you have an advisor that invests all of your different accounts the same or they don’t ask to see your tax return, then you know you don’t have a true tax planning advisor.
Often these advisors are doing audits on portfolios from an investment or risk perspective, and they should be, but often, they only talk about increasing or decreasing the amount of risk you're taking.
But have you ever audited your portfolio from a tax perspective, to make sure that your investments are held as efficiently as possible as it relates to the tax code and risk? Have you ever laid the tax code on top of your retirement income situation?
What do I mean by that?
Limiting Tax Liability
In general, you would want to put more secure investments (like bonds and treasuries) that are most likely to produce income from interest and dividends into a tax-deferred account like a 401(k) or IRA.
Then you can put the growth portion of your investments into a taxable account or tax-free accounts (like a Roth IRA). You would want to start by putting the growth allocation of your investments into a Roth account since you would owe zero tax on the growth over time (which is why we love Roth IRAs).
You would want the next level of your growth investments in a taxable account since long-term capital gains have favorable tax rates when compared with regular income tax brackets.
When you take money from your tax-deferred accounts (like a 401(k) or IRA), you’re going to be taxed at regular income tax rates, but you won’t be taxed annually on the interest and dividends that the investments will produce in those tax-deferred accounts. So, it’s kind of like you’re saving yourself from being taxed twice, since you would have held those interest and dividend earning-holdings anyway.
This asset location mix allows you to maintain your desired asset allocation across your entire portfolio while also reducing your income taxes as your investments grow.
In fact, Vanguard has calculated that proper asset location can boost after tax returns up to .6% per year.
So, let’s say you have a $1,000,000 nest egg, and after withdrawals and investment returns (for simplicity sakes) it stays $1,000,000 every year for the next 30 years, and let’s say we’re optimizing asset location this entire time and gaining the full .6% value, so, we have $1,000,000 x .006 = $6,000 in after-tax funds times 30 years = $180,000. So, it certainly adds up to real dollars and cents!
This is why we focus on asset location and tax planning for our clients. It’s another important arrow in the quiver, we use to limit lifetime tax liability.
Another Way to Reduce Taxable Income
We can also take tax planning a step further. We often transfer money from a client’s tax-deferred traditional IRA to a tax-free Roth IRA by doing Roth IRA conversions.
Many of our retiree and pre-retiree clients benefit from Roth conversions to further reduce their lifetime tax liabilities.
Why Asset Location Matters
So, to add a bit more color, why does asset location really matter?
When money is invested in a taxable brokerage account, capital gains are realized and taxed in the year the investments are sold. Dividends and interest are also taxed in the year they are paid out.
This is similar to how you might earn interest on a savings account and then be taxed on that interest income in the year it was paid. You must also pay income taxes on the earnings in a brokerage account for the year they were earned because that account is a taxable account.
When your money is invested in a tax-advantaged retirement account, such as a 401(k) or IRA, the capital gains and dividends are allowed to grow in the account. They are not taxed until the money is withdrawn from the retirement account.
In the case of a Roth IRA, those capital gains and dividends are never taxed because the money contributed to the Roth IRA was already taxed, and Roth accounts allow money to be withdrawn without paying additional taxes on the growth or earnings.
Why Do I Have Capital Gains if I Didn’t Sell Anything?
You might be thinking that you don’t have to worry about capital gains in your taxable brokerage account because you’re not a day trader and you’re not selling any investments.
It’s true that capital gains come from the sale of an asset in a portfolio, assuming the asset appreciates in value. But if you own mutual funds in a taxable account, you may have capital gains even if you didn’t sell any mutual fund shares during the year.
Capital gains can be incurred when a managed mutual fund you are invested in sells assets within the fund. These fund capital gains are passed on to the shareholders of the fund, as reported on a 1099 form after the end of the year.
Surprised investors recently had large capital gains from Vanguard target date funds that were invested in taxable brokerage accounts.
Target date funds are mutual funds that are commonly used in corporate retirement plans because the funds are managed so that they become more conservative as plan participants get closer to the target retirement date.
The surprised investors had much higher capital gains than expected due to how the funds were managed. They ended up with higher taxable income because they held those funds in taxable brokerage accounts instead of tax-advantaged retirement accounts.
Bottom Line
This is why we focus on asset location and tax planning for our clients.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.