Editor’s note: This is part six of a seven-part series. It dives more deeply into the second strategy for defusing a retirement tax bomb, implementing asset location. If you missed the introductory article, you may find it helpful to start here.
Most investors have heard of asset allocation, but asset location is another story – and it could help investors with large tax-deferred savings reduce their tax bills in retirement.
Asset allocation refers to how a portfolio is allocated to various asset classes that have different historical investment returns and standard deviations. The simplest example is a stock-bond allocation, such as a 60% stock, 40% bond allocation, which is a common allocation for retirees. But there are dozens of more granular asset classes that can be managed as well, for example, U.S. large cap stocks or international small cap value stocks. Asset allocation is critical to effectively diversify your portfolio and reduce risk.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Asset location is different portfolio management strategy: one that few clients I meet have heard of. Few financial advisers implement it as well. Asset location seeks to minimize taxes by placing different asset classes in specific tax buckets (taxable, pre-tax, tax-free).
Putting Asset Location into Practice
In a nutshell, here’s how asset location works:
- Typically, you want to place investments with low expected returns, such as bonds, into tax-deferred accounts.
- Place investments with high expected returns, such as small value or emerging market stocks, into tax-free Roth accounts.
- Place stocks that have the majority of their investment return from capital appreciation (which are taxed at lower long-term gains rates) in taxable accounts.
Asset location can boost after-tax returns because your tax-deferred accounts will grow more slowly (and so will your future tax liability), while your tax-free accounts will grow the most.
However, it can be difficult to implement because each investor's situation is different and can have different combinations of taxable, tax-deferred and tax-free investments. It can be further complicated by mutual fund or ETF holdings that blend different asset classes, such as a growth and income fund or a target date fund, which might typically implement a 60% stock, 40% bond allocation. To implement asset location effectively, you want investments that are very “asset class pure,” so you’re confident you have asset classes in the right tax buckets.
What Asset Location Can Do for You
Let’s look at a simple example of asset location, using the 40-year-old couple from prior articles in this series. They have a $500,000 portfolio, except this time let’s assume it’s 50% pre-tax and 50% Roth, and they want an overall 70% stock, 30% bond asset allocation. For simplicity, I’ll assume no further contributions in this example.
Scenario one: No attempt at asset location
Assume the same 70-30 allocation is implemented in both the pre-tax and the Roth accounts, meaning asset location isn’t being optimized. I see this frequently, even from advisers who are supposedly offering fiduciary managed accounts. The blended annual return in each account would be 8.5%, and after 25 years, the couple would have $2.15 million in the pre-tax account and $2.15 million in the tax-free Roth account as they head into retirement.
Scenario two: Putting asset location to work
Assume the same pre-tax and Roth balances, but this time asset location is implemented. The tax-deferred account holds 100% of the bonds ($150,000) and $100,000 of stocks. Meanwhile, the Roth account holds 100% stock ($250,000). It’s the same overall 70-30 allocation, meaning the same aggregate risk and 8.5% expected return. But after 25 years, the tax-deferred account grows to only $1.6 million (26% less), while the tax-free Roth account grows to $2.7 million (26% more). That makes an enormous difference in tax liability the couple will face in retirement.
The final article in this retirement tax bomb series examines the third strategy for defusing a retirement tax bomb, Roth conversions.
- Part 1: Is Your Retirement Portfolio a Tax Bomb?
- Part 2: When It Comes to Your RMDs, Be Very, Very Afraid!
- Part 3: Watch out! RMDs Can Trigger Massive Medicare Means Testing Surcharges
- Part 4: Will Your Kids Inherit a Tax Bomb from You?
- Part 5: How to Defuse a Retirement Tax Bomb, Starting With 1 Simple Move
- Part 6: Using Asset Location to Defuse a Retirement Tax Bomb
- Part 7: Roth Conversions Play Key Role in Defusing a Retirement Tax Bomb
- Bonus article 1: 2 Ways Retirees Can Defuse a Tax Bomb (It’s Not Too Late!)
- Bonus article 2: Can My Pension Trigger a Retirement Tax Bomb?
-
I'm a Financial Pro: This Is How You Can Guide Your Heirs Through the Great Wealth TransferFocus on creating a clear estate plan, communicating your wishes early to avoid family conflict, leaving an ethical will with your values and wisdom and preparing them practically and emotionally.
-
To Reap the Full Benefits of Tax-Loss Harvesting, Consider This Investment Strategist's StepsTax-loss harvesting can offer more advantages for investors than tax relief. Over the long term, it can potentially help you maintain a robust portfolio and build wealth.
-
Social Security Wisdom From a Financial Adviser Receiving Benefits HimselfYou don't know what you don't know, and with Social Security, that can be a costly problem for retirees — one that can last a lifetime.
-
Take It From a Tax Expert: The True Measure of Your Retirement Readiness Isn't the Size of Your Nest EggA sizable nest egg is a good start, but your plan should include two to five years of basic expenses in conservative, liquid accounts as a buffer against market volatility, inflation and taxes.
-
New Opportunity Zone Rules Triple Tax Benefits for Rural Investments: Here's Your 2027 StrategyNew IRS guidance just reshaped the opportunity zone landscape for 2027. Here's what high-net-worth investors need to know about the enhanced rural benefits.
-
The OBBB Ushers in a New Era of Energy Investing: What You Need to Know About Tax Breaks and MoreThe new tax law has changed the energy investing landscape with expanded incentives and permanent tax benefits for oil and gas production.
-
Ten Ways Family Offices Can Build Resilience in a Volatile WorldFamily offices are shifting their global investment priorities and goals in the face of uncertainty, volatile markets and the influence of younger generations.
-
Should Your Brokerage Firm Be Your Bookie? A Financial Professional Weighs InSome brokerage firms are promoting 'event contracts,' which are essentially yes-or-no wagers, blurring the lines between investing and gambling.
