Using Asset Location to Defuse a Retirement Tax Bomb

Investors can set themselves up for lower tax bills in retirement using a strategy few folks are familiar with: asset location. The idea behind it is simple, but implementing it can be a bit tricky.

A woman deposits money into one piggy bank among a line of many others.
(Image credit: Getty Images)

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.

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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 will examine the third strategy for defusing a retirement tax bomb, Roth conversions.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

David McClellan
Partner, Forum Financial Management

David McClellan is a partner with Forum Financial Management, (opens in new tab) LP, a Registered Investment Adviser that manages more than $7 billion in client assets. He is also VP and Head of Wealth Management Solutions at AiVante, a technology company that uses artificial intelligence to predict lifetime medical expenses. Previously David spent nearly 15 years in executive roles with Morningstar (where he designed retirement income planning software) and Pershing.  David is based in Austin, Texas, but works with clients nationwide. His practice focuses on financial life coaching and retirement planning. He frequently helps clients assess and defuse retirement tax bombs.