With Your Investments, Think Location, Location, Location
Tax diversification is as important as investment diversification: By focusing on what investment goes into which account, you get smarter about how your money grows and, ultimately, how much of it you keep.
If you're an investor, you've probably heard of the 60/40 rule. Long seen as a tried-and-true way to invest in the stock market, this approach suggests allocating 60% of a portfolio to stocks for growth and 40% to bonds for income and stability.
The idea sounds simple, but it's missing a crucial part of the investing equation: Where you hold those investments can matter just as much as what you invest in.
Asset allocation vs asset location
- Asset allocation is the balance of stocks, bonds and other investments in your portfolio
- Asset location is about where those investments live
You could have the same overall mix of investments and risk level in a variety of accounts, but you could get a more tax-efficient long-term outcome by putting the right assets into the right accounts.
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By being more intentional about what investment goes where, you're not changing the level of risk, but being more intentional about tax treatment and how distributions may be taxed over time.
In other words, tax diversification is as important as investment diversification.
Understanding the three tax buckets
Every investment account you own likely falls into one of three main tax categories, or what we call "tax buckets."
Pretax accounts. The first tax bucket includes popular investment accounts such as traditional IRAs, 401(k)s, 403(b)s and other similar plans.
Contributions are tax-deductible today, growth is tax-deferred, and withdrawals are taxed as income and subject to required minimum distributions (RMDs) later in life.
After-tax accounts. The next two accounts are investment or brokerage accounts that aren't tied to any special tax advantages, such as a 401(k) or IRA.
You pay taxes each year on interest, dividends and any realized capital gains. They allow you to withdraw money at any time with no penalties, but growth is taxed as income.
Tax-free accounts. You pay taxes on contributions up front with after-tax dollars; then growth and withdrawals are completely tax-free.
Some examples of these accounts include Roth IRAs, Roth 401(k)s, 529 savings plans and properly structured life insurance.
Having money spread across these three buckets provides tax diversification, giving you the flexibility to draw income from a variety of sources in retirement.
If tax rates rise in the future, you can draw income from your Roth. If they fall, you might pull money from your pretax accounts.
Managing which bucket you pull from each year can also help control your taxable income and prevent surprises with Medicare premiums or Social Security taxation.
When asset location really matters
One of the best examples highlighting the importance of asset location involves annuities. These guaranteed income sources are often misunderstood, and part of that confusion comes from the assumption that annuities should be funded with after-tax money because they provide tax deferral.
But that strategy can create problems. If you use after-tax dollars, all your gains inside the annuity are taxed as ordinary income, not the lower long-term capital gains rate.
Your beneficiaries don't get a step-up in cost basis, and if you're under age 59½, you could face a 10% penalty on withdrawals.
On the other hand, if you fund the annuity with pretax money inside an IRA, those issues go away, because the tax rules naturally align as both are tax-deferred and fully taxable at withdrawal.
Avoiding the RMD tax trap
Asset location also helps avoid one of the biggest surprises facing retirees when they reach their early 70s: RMDs.
Traditional wisdom says to save diligently in pretax accounts under the assumption that you'll pay lower taxes in retirement. But for many, that's not how it plays out.
Instead, they face forced withdrawals that can push them into higher tax brackets, increasing Social Security taxation, even raising Medicare premiums. This is why tax diversification and strategic Roth conversions can be so powerful.
Finding the proper balance
Asset allocation still matters, but asset location determines how much of your return you get to keep. By understanding how different accounts are taxed and aligning your investments accordingly, you can make your money work more efficiently without necessarily taking on more risk.
If you're not sure whether your investments are in the right places, now may be a good time to review your strategy.
A financial adviser can help you uncover those opportunities, evaluate strategies that may improve tax efficiency over time and support your overall retirement plan.
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