You Could Gain Tax Benefits by Coordinating Investments With Accounts

Do not sacrifice efficiency for simplicity.

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One area that generates a lot of questions from prospective clients has to do with our recommendations surrounding Asset Location and generating cash for retirement income withdrawals. In addition to Asset Allocation, which is the percentage mix of stocks to bonds and among the sub-categories, Asset Location is a strategy that matches the tax characteristics of the different types of investment accounts (taxable, tax-deferred, and tax-free) with the tax characteristics of the investments in order to maximize the tax efficiency of the portfolio.

Essentially, investments are considered “tax-efficient” when they qualify for special income tax rates, which are usually lower than the investor’s ordinary tax rate. Qualified stock dividends and gains from the sale of an asset held for over 1 year qualify for the lower tax rates. Investments that do not qualify for the lower rate and instead are taxed at ordinary rates are considered “tax-inefficient,” such as interest-paying fixed income investments.

Asset Location aims to place tax-efficient investments (stock-oriented holdings) in a taxable account, such as a non-retirement or a trust account. Tax-inefficient investments (corporate bonds, CDs, real estate holdings) are placed in a tax-deferred account, such as a Traditional IRA, 401(k), or 403(b). This placement allows the investor to utilize the lower rates within the taxable account and to defer the tax on holdings taxed at the ordinary rate. The same allocation of investments is held in a strategic location, which can reduce the amount of taxes due each year. Over time, this can add up to significant savings and increase the longevity of a portfolio.

While this sounds great, we sometimes find retirees doing the opposite by holding their stock investments in a tax-deferred account (Traditional IRA) and their fixed income in a taxable account. This is typically the case when the plan is to draw from a taxable account until sometime in the future when withdrawals will come from an IRA. The idea being that the fixed-income should go into the account that will be used for withdrawals.

Though this approach does simplify the retirement cash flow, it can lead to more in taxes than necessary. The question is then, ‘How do I generate the cash for withdrawals in a taxable account if all or most of the fixed-income is in a tax-deferred account?’ There are a few ways to support the income withdrawals:

  • Regularly maintain up to 3 months of withdrawals in cash
  • Receive dividends and capital gains distributions in cash
  • Keep a portion of proceeds from sales in cash, reinvest the balance
  • Rebalance the portfolio by liquidating positions in an over-weight category

This total return approach is a bit more complex to manage, but the potential benefits far outweigh the additional work involved. By integrating the location of holdings with the overall allocation, a portfolio can be best positioned to be tax-efficient, provide the necessary withdrawals for retirement income, and also maintain the appropriate allocation – all important elements of a successful retirement plan.

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