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How Tax Location Benefits Your Retirement

Tax Location is a Crucial Component of Retirement Success 

Tax-location is the most overlooked and underappreciated tool for maximizing after-tax spending and wealth in retirement. As tax-savvy retirement planners we attempt to offer value to our clients in a number of different ways; however, tax location often takes the cake as the most valuable change we make to a retirement portfolio.

Yet, most individuals planning for retirement have never heard of tax location even though the concept itself is rather intuitive. More, most financial advisors do not offer tax location for the simple reason that it is often a manual process that takes extra work and time on their end and it can be challenging to implement at scale across their entire client base. 

We believe in you should insist on working with a retirement planner who is well-versed in tax location and is able to implement an effective and tax-sensitive investment portfolio on your behalf. 

What is Tax Location? 

Tax location is an important strategy for making your investment portfolio more tax-efficient. Essentially, the various types of retirement accounts have different tax structures and implications. For example: 

  1. Deferred Accounts: These accounts grow tax-deferred and income tax is due upon withdrawal
  2. Roth Accounts: Roth accounts are essentially tax-free as any growth, income, or withdrawals are not taxed. Income tax was paid prior to contribution. 
  3. Taxable Accounts: Income from dividends, bond interest, and capital gains are due in the current tax year. 

Because the various accounts have different tax implications, they should also hold different types of investment assets that take advantage of each respective account types' positives while minimizing their negatives. Put simply, different asset classes belong in different tax buckets. That's tax location. 

Now, though most individuals will have the bulk of their investable net worth in one type of account or another (i.e. if you sold a business, your taxable account is likely your largest; If you consistently saved into your workplace 401k, the bulk of your investments are likely in tax-deferred accounts), let's presume that you have at least a little bit of money in each type of account. What account type should hold what investment type?  

There are three main buckets for tax location: deferred-style investment accounts, taxable accounts, and Roth-style accounts.

What kind of asset classes should IRAs and other deferred accounts hold? 

Deferred accounts, like Traditional IRAs, 401ks, and 403b's, should hold income-producing assets to decrease your taxable income. Bond interest is taxed at ordinary income rates. So, if bonds make up a portion of your portfolio, and you don't want to pay taxes on the interest payments, it may best to put those bonds in your IRA or another tax-deferred account. 

High dividend paying stocks or international shares may be most suitable for deferred accounts, For example, if there was a chance that dividend income from your portfolio would push you into a higher marginal tax rate, it may be best to hold these types of assets in a deferred-style account. International shares may pay unqualified dividends or have other tax complications when held in a taxable account. If so, lean toward deferred accounts for these holdings.

Finally, if you own any alternative asset classes, like REITS, TIPS, managed futures, or commodities, these may also may be best held in a tax-deferred account. 

What kind of asset classes should Roth IRAs and Roth 401ks hold? 

Roth-style accounts should hold assets with the highest potential for growth. In most cases, the best asset class to hold in Roth-style accounts is stocks. If it makes sense, based on your specific situation and risk profile, to get more granular than that, we often recommend tilting Roth accounts into Small-Cap Value stocks and maybe even Emerging Markets stocks due to their high risk/reward profile historically. 

Why should as much of your growth allocation as possible go into Roth accounts? Because Roth-style accounts not only shelter their holdings from any annual dividend or capital gains income, they are not taxed at withdrawal either. In other words, once money is in a Roth account, and you wait until age 59 1/2 to take withdrawals so that you avoid early-redemption penalties, Roth holdings are never taxed again.

From a financial planning perspective, this signifies that Roth assets should generally be considered your longest duration asset. It is the last account you want to take distributions from in retirement. And because it's your longest duration asset, volatility matters less. If you're not going to touch the account for 20 or 30 years, why not own asset classes with the greatest ability to grow and compound? 

What kind of asset classes should taxable accounts hold? 

Taxable accounts generally fall in-between deferred and Roth-style accounts from a risk/reward perspective. If possible, you don't want taxable accounts to create much income, so income-producing assets like bonds or high dividend paying stocks should largely be planted in your IRA. Conversely, higher risk/reward asset classes like small-cap stocks are most efficiently held in a Roth IRA. 

In practice, we find taxable accounts to be most suitable for core domestic stock exposure, like investing in U.S. Large-cap stocks. If it's necessary to maintain some liquidity in the taxable account, municipal bonds may be a good option to consider. Importantly, tax-managed strategies or indexed-based stocks allocations should be a strong consideration as well to ensure excessive trading doesn't trigger unexpected capital gains tax on your tax return.  

Tax Location Case Study

Jim and Pam are a married couple with a $2,000,000 investment portfolio. They retired three years ago and at the suggestion of their financial advisor and tax advisor, they have been doing Roth conversions annually for the last three years. Their tax diversification looks this: 

  • $300,000 in Roth IRA accounts
  • $700,000 in taxable accounts
  • $1,000,000 in Traditional IRAs

Based on their retirement income plan, and in consultation with their advisor, Jim and Pam have decided on a 70% allocation to stocks and a 30% allocation to bonds for their investment portfolio. How will they best allocate their portfolio from a tax location perspective? 

  • 15% of their portfolio, or $300,000, will be allocated to US Small Cap Stocks in their Roth IRA. This makes up 100% of their Roth IRA. 
  • 35% of their portfolio, or $700,000 will be allocated to US Large Cap Stocks. This will be 100% held in their taxable account. 
  • 30% of their portfolio, or $600,000, will be allocated to high quality US fixed income. This will be 100% held in their Traditional IRAs (or deferred-style accounts).
  • 20% of their portfolio, or $400,000 will be allocated to International stocks. This will be 100% held in their Traditional IRAs, as well. 

As you can see, tax location is a pretty simple concept at its root, but it can grow in complexity based on the financial plan or your personal balance sheet. In our view, it's best implemented with input from your financial advisor or qualified tax professional. If you'd like support in designing a tax-efficient portfolio and implementing a strategic tax location policy, we'd love to help.

Schedule a free introductory below with our team of tax-savvy and experienced retirement experts to see if we can be of service toyour retirement planning needs.

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