From Retirement Now Newsletter 2-24-2022
Came across a good article discussing tax implications that retirees can potentially face if they don’t take asset location into account.
What is asset location?
Here’s some high points from the article that also defines Asset Location:
– “Asset location is the practice of choosing what investments to place in what accounts based on the tax treatment of the accounts with the intent of improving outcomes across an entire portfolio.”
– Some experts are saying that Asset Location is one of the most important planning strategies to use now, maybe even more important than Asset Allocation.
– Some investors in retirement target date funds got burned with some “painful tax bills” because they used non-qualified funds (that is non IRA, 401k, etc.) in the target date fund, and when that fund realized some capital gains, they had to pay unexpected taxes.
– The investors should have been practicing Asset Location and using retirement funds inside the target date funds… things like IRA’s or 401k’s or even Roth IRA’s because they allow for tax-deferral instead of realizing capital gains each year. And in the Roth’s case, even the gains are tax-free.
– Inflation can cause even more problems with taxes, making Asset Location an even more important issue. “Inflation could mean higher bond yields, triggering higher taxes for bondholders. Stock investors may find they pay higher taxes when corporate earnings benefit from higher prices.”
My two cents…
IRA’s, 401k’s, and Roth IRA’s are no secret. But the application of allocating your portfolio across them in a tax efficient manner is another thing entirely. It’s like a secret hidden in plain sight.
Asset Location principals guide us on which investments typically should be in which types of accounts.
Investments that are tax inefficient (in other words they spin off income like dividends, capital gains, or interest income) on a significant basis are better suited in tax-deferred accounts like IRA’s because you won’t have to pay tax on this income as long as it remains inside the IRA.
Investments that are tax efficient (in other words they don’t spin off a lot of taxable income each year) are typically better suited for taxable accounts… since they aren’t generating much taxable income each year.
An example of this would be a stock that doesn’t pay much, or any, in dividends and the investor is going to buy it and hold it for a long time. Since it pays little to no dividends it won’t generate much taxable income each year. And if the investor is holding it for the long-term, it won’t generate capital gains from a sale of the stock. And eventually when the investor does sale the appreciated investment it will be taxed at the more favorable long-term capital gains tax rate.
I believe that Asset Allocation comes first.
Pick an allocation of stocks and bonds that meets your goals of not being too volatile, but also provides enough expected return to meet your growth needs for retirement.
Once that is done, place the more tax inefficient investments in the tax deferred accounts, and if you must, place the more tax efficient investments in the taxable.[But be careful, this doesn’t mean withdraw a big portion of your 401k to then buy stocks in a taxable account. Whenever you withdraw from a 401k or IRA it is a taxable event, so it’s oftentimes better to just keep your stocks inside a 401k or IRA if the alternative is to cause a big tax bill today and lose the tax-deferral they currently enjoy.].
Also, assets that have high expected returns can do very well in Roth IRA accounts, since all the growth is tax-free.
In reality, when you retire you probably have the bulk of your portfolio in a 401k, which is tax-deferred. You may not have much in Roth IRA’s. But over time you may do Roth conversions and increase your holdings in that type of account.
Asset Location would argue that those Roth accounts are better suited for your high growth investments, like stocks. But stocks may also be very suitable for a non-qualified (i.e. taxable account) if you are not trading them actively and incurring short-term capital gains, which are taxed at regular income tax rates.
The lower expected return investments that generate consistent income, like bonds which pay interest, are usually best suited for those tax-deferred accounts.
Much could be said, and has been said (and written) on this topic. Far beyond what most normal people are even interested in knowing.
I have barely scratched the surface in this email, and there is more you need to know before you start trying to optimize your portfolio using Asset Location principals.
But it’s good to know at least the basics mentioned above.