I was reviewing a prospective client's information the other day, who had assets across a variety of investment types – a mix of account locations. As we spoke, I was reminded of an axiom from my days in real estate: location, location, location!
The significance of asset location is as true when the asset is a financial investment as it is when the asset is a piece of property.
NAÏVE VS. OPTIMAL ALLOCATION ACROSS 3 INVESTMENT TYPES
Typically, clients will come to me with a mix of taxable, tax-deferred (Profit Sharing Plans, 401k, IRA) and tax-free (Roth IRA, Roth 401k) accounts. What you put into those accounts (the location) really does matter.
Take the hypothetical naïve case below. It assumes a 60/40 asset allocation (60% stocks, 40% bonds) is correct for this investor:
See how the allocation is the same across all of the accounts. While the asset allocation may be correct (Monte Carlo tested asset mix designed to meet the client’s need for risk and return), the asset location (taxable, tax-deferred or tax-free) has a lot of room for improvement.
Now look at the optimal allocation below. Here the asset location issues are addressed correctly, again assuming the 60/40 asset allocation is correct for this investor (NOTE: to keep the illustration simple, this example does not include any alternative investments, which we usually recommend to clients):
Let’s take a closer look.
Taxable Account: We have placed the international investments here to be able to capture the foreign tax credits. If the foreign investments are held in tax deferred or tax free accounts, you cannot claim the dollar for dollar tax credit.
Taxable and Tax-free Accounts: We have placed the investments most likely to grow over time – equities (both U.S. and international) – in these accounts.
- Taxable: When withdrawals are made, they will be taxed at a more favorable capital gains rate, not as ordinary income. Additionally, should the investor pass away, the assets will pass to the beneficiaries tax free assuming the investor is under the current (and very high) estate tax lifetime exemption amount ($11.18 million for an individual and double that for a married couple, starting in 2018).
- Tax-free: We have placed 100% equities in the tax-free Roth account. Equities will likely grow faster than fixed income and thus any withdrawals taken during the individual's lifetime will be tax free for them and for their beneficiaries.
Tax-deferred Account: Here is where we have placed all of the fixed income to achieve two important goals.
- Goal #1: Avoid paying unnecessary taxes after age 70.5. We want to temper the growth of these accounts, and thus reduce the distributions – called RMDs – you will be required to take and pay taxes on starting at age 70.5. I have seen so many cases where prospects will be facing IRAs with huge RMD liabilities down the road. Taking corrective action earlier will help to temper that growth and place it where it will be more favorably taxed (taxable accounts or Roth IRA), if taxed at all.
- Goal #2: Avoid paying unnecessary taxes before age 70.5 (or at least before you start taking voluntary withdrawals, which you can start at age 59.5). Fixed income growth (unless investing in muni bonds) usually comes from interest, which is subject to ordinary income taxation in the year earned. It wouldn’t make sense to have these assets in a taxable account first, because they won’t benefit from any tax breaks. Holding them in a tax-deferred account allows you to defer that income until later.
This is why, if it makes sense to hold fixed income, hold these assets in your IRA or 401k first. This will help temper the growth of the accounts and thus minimize your future RMDs. Your best growth potential will come from other accounts better equipped to handle that growth from a taxing perspective.
THE PROOF IS IN THE NUMBERS
We created a model to put some numbers behind these recommendations, and the tax savings were dramatic. In each case, we began with an individual investing $2.5M at age 40 and contrasted a naive vs. an optimal portfolio.
Each portfolio started the same in aggregate. Only the location of the assets drove the tax savings. Here’s what happened:
Scenario 1: Liquidate* at age 59.5
- Tax Savings in Optimized Portfolio = 17%, or $309,790
Scenario 2: First RMD at age 70.5
- Tax Savings in Optimized Portfolio = 55%, or $110,450 on the first RMD
*This is for the purpose of modeling only, to demonstrate the savings.
If this isn’t proof enough that asset location is of the utmost importance, imagine we ran this model further out. The results would only get more dramatic with each passing year. Remember that it is only your first RMD that you must take at age 70. If you live to be 95, there will be 24 more RMDs on which you will be taxed, and they accelerate for a period of time as you age.
The bottom line: The amount of additional tax you pay on accumulated wealth during your spend-down years when you don’t start early with optimal tax mitigation in mind is staggering.
SEE WHY WE SAY IT 3 TIMES?
Location, location, location!
As the above hypothetical examples show, asset allocation may be the same for both scenarios, but the eventual tax savings from the second scenario is dramatic. It’s easy to see why, when it comes to investing, location matters.
Now, let’s take a look at your allocation. Is your portfolio optimized across these investment types for tax mitigation? Contact us today to find out if your “properties” are in the best part of town – or whether you’re missing out on the best results the market can offer.
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The opinions expressed by featured authors are their own and may not accurately reflect those of the Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.