The Asset Location Rule for Income Investments in Retirement

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You've built a retirement nest egg and are ready to retire.

Congratulations! You've done the hard work. But now it's time for the nitty-gritty details that can make a major difference in how much of your retirement income you actually get to spend on yourself … and how much you have to share with Uncle Sam.

Most retirement planning conversations focus on what to invest in — or asset allocation. Far fewer address something equally important: where to hold those investments, or asset location.

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In your working years, asset location is mostly about building wealth efficiently and avoiding realized capital gains. In retirement, it shifts to a different priority: generating income with the least possible tax friction.

Different income-generating investments are taxed at very different rates. Some, for instance, are taxed as ordinary income at marginal rates as high as 37%. Other investment income qualifies for preferential treatment and are taxed at rates of 0%, 15%, or 20%.

If you're like most investors, your wealth is spread across a variety of sources, including IRAs, Roth IRAs, corporate 401(k) plans and regular taxable brokerage accounts.

Today, we're going to cover how to distribute your investments across these accounts to make the most of the tax code. Getting this right might make the difference between retiring in style and just getting by.

What is "investment income" exactly?

We should start with a fundamental question. What is investment income?

Traditionally, this has referred to dividends from stocks and interest from bonds. But over the past quarter century, most of which saw yields on traditional income investments at historic lows, many investors and financial advisers have taken a broader view that includes sales of appreciated investments.

Your Nvidia (NVDA) or Microsoft (MSFT) shares aren't likely to ever pay you meaningful dividends, but you can always sell shares to generate cash.

Short-term capital gains — along with interest on bonds, certificates of deposit (CDs) or savings accounts — are taxed at your marginal tax rate. Depending on your income tax bracket, that could be as high as 37%.

Long-term capital gains — along with qualified dividends — are taxed at preferential rates of 0%, 15%, or 20% depending on your income bracket.

Married couples filing jointly who make up to $98,900 pay zero on their qualified dividends and long-term capital gains. Couples with taxable income between $98,900 and $613,700 pay 15%. And couples with taxable income over $613,700 pay 20%.

What goes where?

Now for the details.

There are three buckets: taxable accounts, traditional IRAs and 401(k) plans, and Roth IRAs and Roth 401(k) plans.

The Roth accounts, which allow you to make after-tax contributions to your retirement account, are clearly the cleanest. You pay no taxes on any income as it is earned — dividends, interest, capital gains, etc. — and your distributions are also tax-free. In a perfect world, your entire nest egg would be invested in a Roth account.

Unfortunately, that's not going to be the case for most investors. Due to income limitations in your earnings years, Roth accounts tend to be relatively small for most retirees.

Regardless, this is where you should put your most tax-efficient investments. Bonds, stocks that pay non-qualified dividends such as real estate investment trusts (REITs), and strategies that throw off a lot of short-term capital gains should all be prioritized for your Roth accounts.

The math gets a little more complicated for traditional IRAs or 401(k) plans. You owe no taxes on investment gains, but your distributions are taxable as ordinary income.

Here's where the math comes in. Let's say you make about $90,000 with your spouse. You'd qualify for the 0% qualified dividend rate, but you'd be in the 12% bracket for ordinary income. The last thing you'd want to do is "convert" your tax-free dividends into taxable ordinary income, but that's exactly what would happen for qualified dividend income that you distributed from your IRA.

It gets even more extreme at higher brackets. Those dividends you might normally owe 15% to 20% on could get taxed at 35% or more.

So, to the extent possible, try to keep your qualified dividend stocks and investments that you're planning to sell at long-term capital gains in your taxable account and use your traditional retirement accounts to hold any tax-inefficient investments you didn't have room for in your Roth accounts.

As for your taxable account, this is a great place to hold positions you plan to sell for long-term capital gains (or never sell at all) or qualified dividend stocks.

Of course, the "ideal" asset location may not always be possible. Perhaps a disproportionately large share of your portfolio is in an IRA account, and you simply don't have anywhere else to hold your core dividend payers or the stocks you plan to sell for long-term capital gains.

If so, don't worry. You should remind yourself that you already received a tax break when you contributed to the IRA, and that all of your earnings over the years have also been tax-free. If you pay a little more tax than ideal on your distributions, those other benefits almost certainly made you come out ahead.

You also shouldn't let taxes alone drive your investment decisions. Taxes are a factor. A big factor, in fact. But overall asset allocation is clearly more important than asset location in managing risk and avoiding potentially catastrophic losses.

Charles Lewis Sizemore, CFA is the Chief Investment Officer of Sizemore Capital Management LLC, a registered investment advisor based in Dallas, Texas, where he specializes in dividend-focused portfolios and in building alternative allocations with minimal correlation to the stock market.