Disclaimer: There are many factors to consider when creating an asset allocation and asset location strategy. Please be aware that the situations I present in this article may not be appropriate for your situation. You should always consult with your financial planner or tax adviser regarding this topic.

Retirement is the fun time when you stop saving your hard-earned money and you start to spend it. You stop receiving a paycheck from an employer and start receiving a paycheck from your savings. If you are the average saver, then you most likely utilized three different kinds of accounts to accumulate your retirement savings.

Taxable – brokerage accounts such as joint and individual.

Tax-deferred – retirement accounts such as IRA, 401k, 403b, etc.

Tax-free – Roth accounts such as Roth IRA or Roth 401k.

Reducing tax drag from these accounts is the name of the game. You want to keep more money in your account and away from the government so you can use those dollars to fund retirement goals. With these types of accounts, you can rearrange your asset allocation and asset locations to maximize your tax savings and increase retirement spending.

Each of these types of accounts offer some advantage for taxes but you must know how to use them. Here is a simple breakdown of how each type of account could be taxed.

Tax-deferred – All distributions from these accounts are taxed at your ordinary income rate. The realized capital gains or losses do not have an impact on your taxes. This is because your contributions were deductible from your income at the time of the contribution.

Tax-free – All distributions from these accounts are tax-free. The gains and losses of the underlying investments do not have an impact on your taxes. This is because you funded this account with after-tax dollars and the growth of the invested assets is also tax-free upon withdraw. This is why there is a limit to how much you can contribute to these types of accounts.

Taxable – You could end up paying ordinary income tax as well as short-term and long-term capital gains rates on the investment growth and dividends (so long as they are qualified dividends). Short-term gains are taxed at your ordinary income rate. Short-term losses can offset short-term gains and the same goes for long-term losses and gains. This is called tax loss harvesting. You can also use capital losses to offset $3,000 per year of ordinary income. There are many more rules to taxation of taxable accounts but these are the basics.

As you can see there is a need for sophisticated tax planning to increase tax savings amongst these account types.

Asset Allocation

First, we must consider what type of assets to hold in each account. Assets can be broken down into two categories. Tax-efficient and tax-inefficient.

Tax-efficient assets create less taxable events because you have more control over how the assets or dividends will be taxed. For example, if you invested in a blue chip stock that pays a qualified dividend you could end up paying 0% in taxes on the gains and dividends if you met certain requirements. Some examples include: qualified dividend paying stocks, low-turnover funds, cash or money market funds, and total market stock index funds.

Tax-inefficient assets create more taxable events because they focus on income that can be taxed at your ordinary income rate or they could be an actively managed fund that’s goal is to beat the market. When funds are actively managed they tend to buy and sell the underlying investments often and they could be sold at short-term gains rates which creates a lot of taxable events. Some examples include: high-turnover funds, actively managed funds, real estate or REITs, high yield bonds, or corporate bonds.  

Now that the asset type tax-efficiencies are defined, where should we place them.

Asset Placement

We now know how the types of accounts are taxed and the tax-efficiency, or inefficiency, of some asset classes. To piece this puzzle together we need to find which assets to place in certain accounts. Here is a breakdown and the reasons why for each.

Tax-deferred and Tax-Free

• These are the accounts that you want to put the most tax-inefficient assets. Gains, losses, dividends, interest, or other income will not impact the taxation of the distributions from these accounts. Placing bond funds, REITs, and growth stocks is a good idea.

Taxable

• This is where you place the most tax-efficient investments. U.S. stocks that pay qualified dividends, low-turnover total stock funds, and cash or money markets are good in taxable accounts. If held for the required time, qualified dividends are taxed at long-term capital gains rates which could create a major tax savings depending on your tax bracket. The biggest issue with holding stocks in taxable accounts is that the holdings could appreciate greatly over a long period of time and create a large taxable event if you sold the position. Trimming these positions through rebalancing and proper tax loss harvesting is key to this strategy.

 After placing the right assets in the right accounts, you can then graduate to the proper income strategy to manage your income tax bracket while in retirement. Staying in the lower brackets consistently will prevent any tax burden surprises. I will cover these ideas in my next article but until then review the tax brackets on this handy 2022 important numbers file.

Remember, you should always consult your financial planner or tax adviser before following the information provided here.

Fiduciary Mission

At Integritas Financial, we are committed to providing fee-only, fiduciary financial planning services that are tailored to the unique needs of young professionals, particularly millennials. Our experienced planners work with you to develop customized financial plans that address key areas such as estate planning, trusts and wills, retirement, workplace benefits, education funding, student debt, and buying a house.

We believe in transparent, client-focused service that puts your financial goals at the center of everything we do. As a fiduciary firm, we are dedicated to acting in your best interests, and we never sell products that charge commissions to clients.

Our goal is to help you achieve a stable and prosperous financial future by providing comprehensive financial planning services that are tailored to your individual needs. Whether you're just starting out in your career or you're already well-established, we can help you navigate the complexities of financial planning and create a roadmap for success.

Ryan@if-money.com