We talk a lot about diversifying investments as a way to reduce risk inside of portfolios. While this is critical to a successful financial plan, we cannot forget about another means of diversification – that is among the types of accounts within the portfolio. What do I mean? I’m talking about establishing a mix of accounts with different tax characteristics, being strategic about the types of investments across accounts, and holding tax-efficient investments within each account. This strategy is known as asset location.
There are four types of accounts to consider:
(1) Tax-deferred accounts like 401(k)s and traditional IRAs
(2) Tax-exempt accounts that grow and are distributed tax-free, such as Roth IRAs
(3) Taxable accounts that carry capital gains tax implications
(4) Cash in the bank
Below we describe how a balanced mix of accounts provides flexibility in managing taxes once distributions begin, and how investment selection can impact your current and future tax situation.
Tax-deferred accounts are generally retirement accounts like a traditional 401(k) and traditional IRA. These accounts have some great advantages. For one, contributions are not counted towards income for tax purposes, so there is an immediate tax savings! Contributions then compound over time without any tax consequences inside the account. Since income, dividends, and gains are shielded from taxes, it is wise to hold investments that pay income which would otherwise be taxable, such as traditional bond funds. This income can be reinvested to further amplify compounding. While this is a great savings vehicle, keep in mind that distributions are taxed at ordinary income tax rates. And don’t forget about required minimum distributions, which begin at age 72 under current IRS rules. This could mean a hefty, unavoidable tax bill in the future, so don’t be afraid to “spread the love” across the other account types described below!
This category is home to the Roth IRA, a “fan favorite”! While there is no up-front tax deduction, investments have the potential to grow and are distributed tax free. Many 401(k) plan also offer Roth options, which are not subject to income limits like a Roth IRA. Building a healthy Roth balance over time can provide for tax-free distributions during important phases of retirement. For example, assume an individual retires at age 67, has a traditional IRA and Roth IRA, and does not plan to take social security until age 70. Rather than reaching exclusively into their traditional IRA and paying taxes on all distributions, they might take their distributions from a combination of their Roth IRA, traditional IRA, and cash balances to minimize taxes and avoid exhausting one particular account. From a legacy planning perspective, Roth accounts are also a great way to leave tax-free assets to heirs. The types of investments here should typically mirror those found in tax-deferred accounts because income, dividends, and gains are forever sheltered from taxation.
These are accounts without any handcuffs or distribution rules. Unlike a traditional IRA or 401(k), there are no tax deductions when contributions are made. However, when gains are realized they are taxed at preferential capital gains rates so long as the positions have been held for over one year. This is typically 15% depending on income level. For 2022, this 15% rate applies to taxable income between $41,676 - $459,750 for single taxpayers and $83,351 - $517,200 for joint filers. This is another helpful tool for managing taxes during retirement, as it provides yet another bucket to draw from in order to avoid higher ordinary income tax rates. It’s important to keep an eye on the types of investments held in these types of accounts because income and gains on investments are not sheltered from taxes. For example, it may be to your advantage to hold municipal bond funds rather than corporate bond funds here because municipal bond interest is exempt from federal income tax. Typically, taxable accounts are set up as “Transfer on Death” (TOD), allowing for the designation of beneficiaries and avoidance of probate.
When discussing account mix, we also have to consider cash balances. This is simply cash sitting in a bank account. Why is this so important? Let’s consider a scenario similar to the first few months of this year in which the market is volatile. Rather than taking money from the investment portfolio, it would be ideal to fund expenses with cash. This allows the portfolio to recover, at which time distributions can be made and cash replenished. Having a healthy amount of cash provides a nice buffer when markets aren’t cooperating. We typically recommend retirees build towards a cash balance that would cover at least one-year of living expenses.
Making decisions about funding different types of accounts and paying yourself from these accounts during retirement can be complicated and challenging. Your Stonegate team understands the importance of diversifying your account mix. We have the experience necessary to help you overcome these complex challenges and work towards minimizing your taxes and maximizing your lifestyle. If you have questions about how these accounts work and how they fit into your specific plan, please let us know.
The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. The opinions expressed here are those of Stonegate Financial and not necessarily Raymond James. This material is being provided for information purposes only. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we do not provide advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state or local taxes.
Investors should carefully consider the investment objectives, risks, charges and expenses of mutual funds before investing. The prospectus and summary prospectus contains this and other information about mutual funds. The prospectus and summary prospectus is available from your financial advisor and should be read carefully before investing.