There is a reason why you hear advisors stress diversifying your portfolio strategically depending on your situation, and I am not only referring to asset allocation, that is to say, dividing an investment portfolio among different asset categories, i.e. stocks, bonds, and cash. I am talking about asset location. Asset location is a very important and strategic way to minimize your tax liability and it takes advantage of the fact that different types of investments get different tax treatments. Simply put, advisors determine which securities should be held in tax-deferred accounts, and which securities should be held in taxable accounts to maximize after-tax returns using the tax code to your benefit. When it comes to the distribution of retirement assets, and where those assets are located in the portfolio can have a direct bearing on how much income you receive. There are many facets and fine-tuning for each situation when it comes to determining an overall asset location strategy, but there is a core philosophy for this strategy – holding assets that throw off income taxed as ordinary income in a tax-deferred account, such as a retirement account, and holding assets that primarily produce capital gains in taxable accounts. Let’s take a look at the different types of accounts that are used in this strategy and why it is so important to know how different assets are taxed.
This category includes investments in stocks, investments in bonds, IRAs, 401(k)s, 403(b)s, SEPS, etc. The question here is when you are going to actually pay the tax due. As we are all aware of, the government has a potential share in any investment gains (and losses). Simply put, if an investment that you own loses value, the tax on the investment decreases, ultimately decreasing the amount the government will be paid and vice versa. In another situation, if an investment is in bonds or another asset that is taxed at ordinary income rates, the government would receive more in taxes than an investment that produces capital gains, as ordinary income is taxed higher than capital gains.
Retirement accounts (IRAs, 401(k)s, etc.) have a different way of taxation, as the government collects taxes during the distribution phase at your ordinary income rate whether funds are taken from principal or gains.
The “odd-ball” here is the Roth account. The government does not have any future revenue from this account since the account is funded on an after-tax basis. Though this account has arguably the strictest contribution limitations, it is an option that many take advantage of.
It is not always easy to locate assets in the most effective manner and adhere to the most appropriate asset allocation. In this case, analyzing the specific assets that need to be allocated within a portfolio and figuring out alternatives is the best option.
For example, actively traded stocks should be in retirement accounts so that they won’t be taxed at high short-term capital gains rates. Alternatively, if stocks will be bought and held for a long period of time, they can be placed in a taxable account and unrealized gains won’t be taxed at all, and realized gains will be taxed at lower capital gains rates.
Most bonds and bond funds as well as REITs all belong in tax-deferred retirement accounts, because they are taxable at ordinary income tax rates.
Generally, it is to your advantage to contribute to a traditional retirement plan over a Roth if you expect to be in a lower tax bracket during retirement. But since there’s no way to know what tax rates will do in the future, it’s a guessing game.
Something to consider if contributing to a Roth makes sense in your situation include the fact that distributions aren’t required from Roth accounts, which can make them great estate-planning vehicles, and the fact that they don’t generate taxable income in retirement. If you have a variety of assets to choose from when taking distributions, including traditional retirement accounts, Roth accounts, and taxable accounts, it is easier to mix and match distributions from these accounts to come up with the best strategy for your unique situation.
Although it is important to have a general awareness of tax issues when contemplating retirement, there is no substitute for consulting your tax advisor for advice. Retirement is one of the most important events in life to plan for, however it does not need to be as intimidating as it seems. Please call our office for a complimentary consultation for further information.