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.
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% …….