POSTED ON AUGUST 29, 2023

By:  Shelly Gigante

Shelly Gigante specializes in personal finance issues. Her work has appeared in a variety of publications and news websites.

This article will … Outline the reasons why you may be able to help minimize your tax liability by holding your most tax-efficient assets in your taxable brokerage accounts.  Offer insight on how much you could potentially save by making tax-efficient investment decisions. Explain why asset location strategy may be especially helpful for wealthy retireesnow that the stretch IRA has disappeared.

As an investor, you’re no doubt aware that spreading your investments out among various asset classes, including stocks, bonds, and cash, can potentially help you deliver higher risk-adjusted returns — a diversification strategy known as asset allocation.

But, unbeknownst to many, where you park those assets within your portfolio may also help you reach your retirement goals faster. Enter asset location.

By making strategic decisions about how you distribute your investments among tax-deferred, tax-exempt, and taxable accounts, you could potentially reduce the amount of taxes you owe in retirement and boost your after-tax return — in some cases significantly.

“Most investors are not aware of asset location strategy,” said Greg Hammond, chief executive of Hammond Iles Wealth Advisors in Wethersfield, Connecticut. “Unfortunately, many only follow the mantra that you should save as much as possible on a pretax basis in an IRA or employer retirement account. But they should look beyond this retirement savings default to diversify the types of retirement accounts they are contributing to with an asset location strategy.”

For this, investors need guidance on:

• the tax treatment of different types of investment accounts.
• which assets may potentially be best suited for which type of account.
• who might benefit from asset location strategy.

Here’s a closer look at each.

Asset location explained

Before exploring which assets may be best suited for which type of account, it may help to review the tax-treatment rules for the three main types of investment accounts:

Tax-deferred: These include traditional IRAs, defined contribution plans, such as 401(k)s, and many employer pension plans. In the case of traditional IRAs and 401(k)s, contributions are made on a pretax basis, which yields an immediate tax deduction in the year you contribute. Earnings grow tax-deferred. As such, you must begin taking required minimum distributions (RMDs) from tax-deferred accounts at age 72 (73 if you reach age 72 after Dec. 31, 2022), paying ordinary income tax on the withdrawals, which caps out at 37 percent for federal tax. (Learn more: Retirement plan contribution limits: Your need-to-know)

Generally speaking, if you withdraw money from a tax-favored retirement account before age 59½ you will incur a 10 percent penalty on the amount withdrawn, although a few exceptions exist.

Tax-exempt: These include Roth IRAs and Roth 401(k)s, which are funded with after-tax dollars. There is no tax deduction for contributions, but your earnings and withdrawals are tax-free in retirement as long as you are 59½ or older and you owned the account for at least five years. Another benefit of a Roth account is that it is not subject to RMDs. If you don’t need your savings for living expenses during retirement, your account balance can remain untouched where it can potentially deliver tax-free compounded growth for as long as you live. As a result, Roth accounts can be an attractive tool for retirees who wish to leave an inheritance to their heirs. Roth accounts, however, are not available for everyone. There are income limits that restrict who may contribute. (Related: 8 FAQs on traditional vs. Roth IRAs)

A health savings account (HSA), which is offered by some employers along with a high-deductible health plan, would also be considered a tax-exempt account. All plans are different, but many HSAs are funded with pretax dollars and any interest you earn may grow tax-deferred. When used for qualified medical expenses, however, your HSA withdrawals are tax-free. HSAs need not be depleted at the end of each year, as is the case with a flexible spending account (FSA). Your savings are allowed to accumulate. In many cases, you can invest a portion of your HSA balance for growth, which may help defray health care costs during retirement. (Related: Saving for medical costs: FSA, HSA, or both?)

Taxable accounts: Brokerage accounts, where you buy and sell investments outside your retirement accounts, are taxable. Investments to such accounts are made using after-tax dollars, which establishes the cost basis. Because those dollars have already been taxed, you need not pay taxes on your cost basis when you sell assets in the account, but you will owe long-term capital gains tax on any earnings — as long as you owned the asset for at least 12 months. (Learn more: How to avoid and offset taxes on capital gains)

The top long-term capital gains tax rate is 20 percent, depending on your income. Earnings on assets held for less than a year are taxed as ordinary income, which, again, caps out at 37 percent for federal taxes.

What goes where?

With that background, which assets may be best suited for which types of accounts?

As a general rule, financial professionals suggest that investors can potentially minimize their tax liability by holding their most tax-efficient assets in their taxable brokerage accounts. Those assets include:

• Municipal bonds, which usually don’t incur federal taxes.
• Tax-managed mutual funds.
• Passively managed exchange-traded funds (ETFs).
• Index stock funds, which typically have low turnover so they are less likely to incur capital gains that get distributed to investors.

In addition, Chad Tourin, president of Coastal Wealth in Plantation, Florida, said investments that you plan on holding for long periods of time are best held in taxable accounts because of the preferential tax treatment of capital gains, as opposed to ordinary income tax rates.

Your less tax-efficient assets, then, may be best suited for tax-exempt and tax-deferred accounts, such as your 401(k) or IRA. Those include:

• Stocks that pay dividends.
• Active mutual funds with high turnover rates.
• High-yield corporate bonds.
• Bond funds that generate taxable interest payments.
• Real estate investment trusts.

“Income-generating investments, such as dividend-generating stocks, are ideal candidates for tax-favored accounts, particularly if your plan is to reinvest the dividends,” said Tourin. “This allows you to defer the tax and maximize the rate of return. Mutual funds are also great investments to hold in tax-deferred accounts because you won’t be taxed on the trading of individual positions inside the mutual fund, which often can result in a tax liability even if the portfolio itself has declined in value.” (Related: Mutual fund and ETF basics)

For the same reason, investments you actively trade may also be ideal candidates for tax-deferred accounts, Tourin added.

Putting asset location into practice

To optimize for tax-efficiency, financial professionals generally recommend contributing at least enough to your workplace retirement account to collect the employer match.

If you have an HSA available to you at work, you should also consider contributing to that, to the extent that it meets your family’s financial and health insurance needs. Those who invest a portion of their contributions for growth and allow any earnings to accumulate can potentially make a significant dent in their health care costs in retirement.

And, if you qualify based on income to contribute to a Roth account, consider doing so, as long as it aligns with your tax and retirement planning goals. Remember that there are no RMDs from a Roth IRA or Roth 401(k) when you retire, so those assets can potentially benefit from tax-free compounded growth for years to come.

If you are not eligible to contribute to a Roth during your working years, Hammond said it may be wise to consider a Roth IRA conversion as you enter retirement. Doing so means that you will pay ordinary income tax on your entire account balance, but you will avoid having to take taxable distributions beginning at age 73.

“Beyond that, an investor should look at several factors, including time horizon until retirement, current income tax bracket, investment costs, potential financial goals, and quality of investment options available, to determine the next-best place to save for retirement,” said Hammond. “If a young couple is saving for a down payment on a future home, it does not make sense to add more to the employer retirement plan. This couple may want to look at saving more in a Roth IRA (which allows for penalty-free withdrawals of up to $10,000 for the purchase of a first-time home) or an after-tax investment account, which is liquid.”

While your overall portfolio should be balanced, reflecting your age, tolerance for risk, and target retirement date, remember that you need not allocate investments equally across all accounts. That can get tricky, however. A financial professional can offer valuable guidance in selecting both an asset allocation and an asset location strategy that’s right for you.

How much can I save?

The following bare-bones example provides a rough idea of how much investors could potentially save mathematically by prioritizing tax-efficiency in retirement:

According to Tourin, a hypothetical 65-year-old retiree with $150,000 (5 percent of their portfolio) held in tax-exempt accounts, $350,000 (12 percent) in taxable accounts, and $2.5 million (83 percent) in tax-deferred accounts, could conceivably save $56,000 per year in taxes — or $1.4 million total over 25 years — by simply relocating their assets to reflect the following:¹

• $1.02 million (34 percent) in tax-exempt accounts.
• $990,000 (33 percent) in taxable accounts.
• $990,000 (33 percent) in tax-deferred accounts.

Both portfolios would generate annual income of at least $200,000, he said. That calculation assumes the retiree pays 20 percent in capital gains and 40 percent combined in federal and state ordinary income tax.

But this example doesn’t take into account possible liquidity needs or the long-term goals of an actual individual investor. It merely demonstrates potential savings that might be realized through an asset location strategy. Tax-efficiency alone should never dictate investment decision-making.

Those nearing or already in retirement may not necessarily be good candidates for a significant reallocation of their tax-deferred retirement assets because they no longer have the time horizon to compensate for the upfront tax bill they would incur. Withdrawals from a tax-deferred account are taxed at ordinary income tax rates.

A financial professional can help you determine your liquidity needs in retirement and ensure that your investments are distributed in a way that aligns with your unique goals.

Who might benefit most from asset location

Those with a majority of their retirement assets held in 401(k)s and other tax-deferred accounts are among those who may benefit most by adopting an asset location strategy.

“If you only contribute to a before-tax retirement account, all your retirement income from the retirement account will be taxable when it is distributed to you,” said Hammond. “Many investors think they will be in a lower tax bracket when they retire, but I do not come across many people who want to have a lower income in retirement.” Having additional funds invested in tax-free accounts like a Roth IRA and after-tax investment accounts provides flexibility to control how much taxable income you want to incur in each year of your retirement, he said.

Others who potentially stand to gain from an asset location strategy include taxpayers who fall into the highest marginal income tax rate, those who expect to pay a lower income tax rate in the future, and/or investors who hold a mix of stocks and bonds, which allows for rebalancing flexibility.

Lastly, those who hope to leave a financial legacy for their heirs may be good candidates, particularly now that the stretch IRA has disappeared, said Hammond.

“Although a pretax employer retirement plan may be a great way to save for retirement for you, it will be a ticking tax time bomb for your children and beneficiaries who may be in their peak earning years when they inherit your retirement account,” said Hammond. “I am talking more and more to clients about Roth IRA conversions to reduce future tax liability and implement an asset location strategy.”

When managing their tax liability, investors should remember that asset location strategy is merely one lever that they may pull. A tax or financial professional can also help them determine whether trusts, tax-loss harvesting (selling your investments at a loss to offset capital gains), and whole life insurance (assuming they have a need for death benefit protection) may help them manage their tax liability. Generally, life insurance benefits are tax-free when they go to the policy’s beneficiaries. If you have a permanent policy that accumulates cash value, such as indexed universal life insurance (IUL), that cash value can also earn tax-deferred interest over time. (Learn more: Life insurance: 3 tax advantages)

Conclusion

By being mindful of the tax treatment of your different investment accounts and making strategic choices about which assets you hold where, you may be able to keep more of your hard-earned savings.

That said, tax mitigation alone should never dictate your investment decisions. Your investment portfolio and the assets you hold should first and foremost be appropriate for your risk tolerance and future goals.

The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.

Provided by Christopher Price, courtesy of Massachusetts Mutual Life Insurance Company (MassMutual). California insurance license number: #4196813.
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