When it comes to retirement planning, one of the most important decisions you will make is how to allocate your assets. Different types of investments are taxed differently, so it’s important to understand the tax implications of each choice you make. Many studies have shown that asset location can have a significant impact on your retirement income. In this article, we will discuss the benefits of asset location and show you how to put this strategy to work for you!
Know the 3 main types of investing accounts
1) taxable, 2) tax-deferred, and 3) tax-free.
Most people are familiar with taxable accounts, which include everything from savings accounts to brokerage accounts. These account types are subject to annual taxation on the interest, dividends, and capital gains earned within them.
Tax-deferred accounts are another common type of investment account. These include 401(k)s, 403(b)s, and traditional IRAs. With these accounts, you don’t pay taxes on the money you invest until you withdraw it in retirement.
Finally, there are tax-free accounts, also known as Roth accounts. With these accounts, you contribute after-tax dollars, but all future withdrawals are tax-free.
Now that you know the basics, let’s take a closer look at asset location and how it can help you maximize your retirement income!
There are two main benefits of proper asset allocation:
- It can help you minimize your taxes
- It can help you maximize your returns
How can you benefit from an active asset location strategy?
If you have a mix of taxable, tax-free, and tax-deferred accounts, you can use an active asset location strategy to maximize your after-tax returns. This involves placing assets in the appropriate account type based on their individual tax characteristics.
For example, let’s say you have $50,000 to invest and you are considering two investment options:
- Option A: A bond that pays annual interest of $5000
- Option B: A stock that pays annual dividends of $2000 and has the potential for capital gains
If you hold both investments in a taxable account, Option A will be taxed as ordinary income and Option B will be taxed at the more favorable long-term capital gains rate. However, if you hold Option A in a tax-deferred account and Option B in a taxable account, you will pay taxes on the interest from Option A when you eventually withdraw it in retirement, but you will not pay any taxes on the dividends or capital gains from Option B until you sell the stock.
In this example, an active asset location strategy would result in a lower overall tax bill and higher after-tax returns.
Rate your investments on a tax-advantaged scale
To implement an active asset location strategy, you need to know how each of your investments is taxed. You can use the following to rate your investments
In general, the following are higher on the tax-advantaged scale:
- Individual stocks are, generally, relatively tax-advantaged if bought and held for longer than a year
- Index funds and ETFs that track broad market indexes
In general, the following are lower on the tax-advantaged scale:
- Bonds and bond funds, with the exception of municipal bonds and bond funds.
- Actively managed stock mutual funds that have a high turnover ratio
Locate investments where they may help enhance after-tax returns
So, which investments should you place where to improve your after-tax returns? Each person will have to figure out the best strategy for their particular situation. However, in most cases, depending on your overall asset allocation, you might want to think about putting the most tax-advantaged assets in taxable accounts and the least in tax-deferred accounts.
To employ this strategy, you’ll need a number of accounts with varying tax treatments. Start by focusing on the benefits that may be gained from your current situation. When you reach contribution limits or move contributions to account types with different tax treatments, asset location can be utilized to improve taxable profits even further.
Remember, creating an asset location plan is a difficult task, so enlist the assistance of a financial professional who can help you with asset location as well as assist you in developing a sound financial strategy to help you achieve your financial objectives.