By far, the largest wealth eroding factor we face over the course of our working lives are taxes. Minimizing taxes can have a significant impact in the short term. However, the difference that maximizing and optimizing our tax planning can have over the course of our retirements can be nothing short of profound.
Today, I will discuss the first of the three most crucial tax strategies for a successful retirement. Depending on factors such as the amount of wealth we have accumulated, the types of assets we own, and how long we live, getting these strategies right can mean tens of thousands, hundreds of thousands, or even millions of dollars in additional net spendable income over our lives.
Keep in mind that this is true at today's tax rates. If taxes rise in the future, as I believe they will, these strategies will become even more valuable.
The overwhelming majority of retirees whose plans I have evaluated, regardless of wealth or education level, get these strategies wrong. I would like to change that for you.
Asset Location Strategy:
Asset allocation strategies get most of the attention when it comes to portfolio design and construction. We grapple with the question of what percentage of our assets should be invested in equities (stocks) and what percentage should reside in fixed income (bonds, CDs, etc.) The generally accepted wisdom is that as we get closer to retirement, we should migrate more of our assets from volatile investments like stocks, to the traditionally more predictable stuff like bonds.
This is wise since we can ill afford to take a massive loss on our investments while we are drawing them down in retirement. That is also a well-known concept.
An often-overlooked concept, however, is asset location strategy. To understand how asset location works, it helps to know how different accounts are taxed. The three main types of accounts are:
-Taxable, which includes traditional individual or joint brokerage accounts that can have in them any type of security or ETF.
-Tax-deferred, which includes traditional or rollover IRAs, 401(k)s, and 403(b)s.
-Tax-exempt and subject to certain rules, which include health savings accounts (HSAs), Roth IRAs, Roth 401(k)s, and whole (permanent) life insurance.
Asset location strategy, as the name implies, locates assets that are more tax-efficient in accounts that are taxed at higher rates and places less tax-efficient assets in tax-advantaged accounts. For example, a Roth IRA is a great place to hold the more aggressive investments in your portfolio. Potentially, there will be a higher rate of long-term growth and none of it will be taxed.
On the flipside, you might consider holding investments that pay interest income, such as high yield bonds, and alternative investments like commodities, in accounts like IRAs. The bond interest will not be taxed as ordinary income in the year it is received (as it would be in a standard brokerage account) and the alternative investments can be traded as needed without triggering short-term capital gains taxes.
Instituting an asset location strategy can be difficult to do on your own and that baseline level of complexity becomes magnified across households. Couples will often have multiple accounts like 401(k), IRAs, Roths and traditional brokerage accounts, in each of their names. To be effective, the asset location strategy must take all these into account.
Maintaining an effective asset location strategy can be even more complex as market shifts require rebalancing. For example, if stocks moved strongly higher, to maintain our desired asset allocation balance we would need to sell some equities to buy bonds. In which accounts should we sell stocks to buy those bonds to best maintain the tax efficiency of our asset location strategy?
Given the complexity of overlapping strategies like asset location and asset allocation, consider working with a financial professional who is knowledgeable and whom you trust. The result might be keeping substantially more of the money you have worked hard to save.
If you would like more information on establishing and maintaining a tax efficient retirement plan, call me at 732-844-3000. I'm here to help.
Scott R. McGimpsey December 5th, 2024
Certified Financial Fiduciary®
This material was prepared by Scott McGimpsey and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Neither Cetera Advisor Networks LLC nor Scott McGimpsey is engaged in rendering legal, accounting, or other professional services. If such assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any federal, state, or municipal tax penalty. Moreover, a diversified portfolio does not assure a profit or assure protection against loss in a declining market. Asset allocation is an investment strategy that will not guarantee a profit or protect you from loss; it cannot eliminate the risk of fluctuating prices and uncertain returns. Asset allocation is driven by complex mathematical models and should not be confused with the much simpler concept of diversification. UNIFIED PLANNING GROUP is an independent firm.