Why Does Asset Location Matter?
Asset location is the strategic practice of optimizing the tax treatment of one’s investment asset ownership. It is critically important for building an investment portfolio that reduces overall tax liability.
“Don’t put all of your eggs in one basket.”
This is fitting advice for a multitude of circumstances.
I feel like I’ve written that recently. Oh yeah, this is how I started my post about asset allocation a few days ago.
Well, as it turns out, it was quite a prophetic statement because once again we’re going to discuss the benefits of putting your financial eggs in more than one basket.
This time, however, we’re going to discuss how the metaphor relates to asset location, which shouldn’t be confused with allocation though it is understandable how the two could be mixed up.
Asset Location is All About Tax Efficiency
As a reminder, asset allocation deals with the types of investment assets we own to fit our personal preferences for risk, reward, or meet other financial goals.
Asset location is the type of accounts we hold those assets in for the sake of maximizing tax efficiency.
Let me repeat an important point. Asset location is all about tax efficiency.
Therefore, our discussion will focus on the tax differences between investment accounts and very little on the types of assets therein.
The Three Asset Locations
There are numerous types of tax-advantaged accounts which we will consolidate into three categories based on how they are taxed.
1) Tax-deferred accounts contain assets from which no income, capital gains, or dividend taxes have been withheld, but will be upon withdrawal. The most common examples are Traditional 401(k)s and Traditional IRAs, but there are also 403(b)s, 457, and a variety of IRAs among others.
2) After-Tax accounts contain assets that have already been subjected to taxes but are able to grow and be withdrawn completely tax free. Basically, anything that acts like a Roth 401(k) or Roth IRA fits in this category.
One could argue that 529 and/or HSA assets fit in this bunch too, but we’re going to leave them out of this post for the sake of not overcomplicating things.
3) Taxable accounts are accounts in which the contributions made come from previously taxed dollars and the earnings or gains that are realized within the account will also be taxed.
This could be a standard brokerage account or any sort of savings account that earns interest. For the purposes of this post, we will limit our discussion to taxable brokerage accounts.
The reason we need to understand these different accounts is because their tax treatment is different and, therefore, there are advantages for using the assets in these accounts in different ways to limit tax exposure as much as possible.
Yes, death and taxes are inevitable, but asset location is a path for us to strategize our investments to limit the tax bite when we withdraw funds.
Just by understanding asset location, one could easily save thousands of dollars in taxes over the course of their lifetime.
One other item to bear in mind as we consider this topic is that not all taxes are the same. Income is taxed at the highest rates while capital gains and dividends are taxed at lower rates.
This will be important to understand as we discuss tax efficiency. If you need a refresher, I encourage you to click the link and read that post before finishing this one.
Which Asset Locations Are Most Tax Efficient? (for withdrawals)
We’re not going to veer off into the Roth vs Traditional debate here.
Our focus is from the point of view of one considering the tax-efficient ways to make withdrawals, not contributions.
We’ll assume you’ve already read our post about the best tax-advantaged accounts to optimize your contributions.
Without question, After-Tax assets are the most tax efficient to own because no taxes are due when you withdraw them.
To my knowledge, no one in history has ever complained about having too much money in a tax-free account. In fact, it’s generally better for your heirs too.
Next, come assets in Taxable accounts because the contributions or cost basis of these assets has already been taxed meaning only the earnings portion of the balance is subject to further taxation.
No doubt, you are astute enough to notice that if both contributions and earnings are taxed, then that means the whole balance is taxed.
Right you are. I can’t get anything past you guys.
However, earnings in Taxable accounts that come from assets held for more than one year (meaning they are not bought and sold in the space of less than one year) are not subject to income taxes.
Long-term gains and dividends are subject to capital gains and dividend taxes which are always lower than the corresponding income taxes for the same income level.
(Here’s another link to our post about tax brackets in case you want that refresher.)
We’ll look at an example in a second.
Finally, tax-deferred investments are the least valuable at the time of withdrawal because Uncle Same still expects his due.
Every penny you move, inherit, or convert from these accounts is subject to income tax.
As we’ve already discussed and will now illustrate, income taxes are more costly to you than long-term capital gains or dividends.
Furthermore, tax-deferred investment accounts are subject to Required Minimum Distributions (RMDs), removing even more of the control you have over your tax situation.
An Example
Let’s assume Taxable Tammy has $100,000 in a Taxable account and $100,000 in a tax-deferred account.
Tammy is in the 22% tax bracket and wants to know how much a $10,000 withdrawal from either account will cost her in taxes.
If an After-Tax Roth account was an option, the choice would be simple, but alas Tammy can only use the tools available to her. Oh well.
Tammy’s Taxable brokerage account is made up of ETFs that Tammy has owned for several years that have a cost basis of $85,000 and long-term capital gains of $15,000.
When Tammy makes her withdrawal, she will owe capital gains taxes on $1,500 of the $10k withdrawal.
(This $1,500 is 15% of the $10,000 withdrawal and represents the earnings portion of the funds.)
Fifteen percent (the capital gains tax rate) of $1,500 is $225.
Recall that Tammy has already paid taxes on $8,500 of the $10k withdrawal which is the cost basis or contribution portion. She paid $1,870 on this portion of the withdrawal.
Therefore, Tammy’s total tax liability for the $10,000 from the Taxable account is $2,095.
Had Tammy pulled the $10,000 from her tax-deferred account she would have owed $2,200 in taxes.
So, Tammy can save $105 by making the withdrawal from her Taxable account instead of her tax-deferred account.
Don’t Let the Tax Tail Wag the Investment Dog
At this point, I feel inclined to remind readers that knowing the tax implications of withdrawals doesn’t mean you should necessarily go out and put every penny you can into a Roth retirement account.
Nor should you necessarily favor taxable investing over Roth or Traditional tax-advantaged accounts.
Depending on your income when you make contributions compared to when you make withdrawals, a traditional IRA or 401(k) may be better for you.
For example, if you are in a high tax bracket now, say 32%, and will likely be in an equal or lower bracket when you make withdrawals or are forced to do so through RMDs, a tax-deferred investment vehicle is probably a great fit for you.
The reason is you can save 32% on your contributions now and if you withdraw at say the 22% bracket, you’ve created a tax arbitrage of 10%.
That’s a worthwhile savings.
Remember, all else being equal, there is no advantage to paying the tax on the contribution or the withdrawal*. The net result is exactly the same.
Therefore, if you can predict your tax situation, you’re better off choosing the account type at the time of contribution instead of making assumptions about taxes when you make withdrawals.
(*It is slightly more advantageous to use Tax-deferred accounts in this case because the first withdrawals will probably be taken at lower tax brackets.)
Furthermore, even though it may be cheaper to withdraw long-term gains from taxable accounts than tax-deferred accounts, the previously untaxed growth of a tax-deferred account means it will probably outpace the difference in capital gains and income taxes.
I guess what I’m saying is it’s complicated. You can’t make these decisions without a picture of your entire financial situation.
How Do I Locate My Assets Effectively?
So, what’s the ideal mix?
It depends.
In a perfect world, all of your tax-advantaged assets would be in Roth accounts, and you’d never have to pay taxes on any withdrawals.
This is a highly unlikely scenario for a few reasons.
To begin with, investing solely in Roth accounts would be a challenge due to the early withdrawal restrictions and penalties on the earnings.
Next, there’s only so much you can put into a Roth in a given year. Roth IRA contributions are limited to $6,500 for most contributors in 2023.
Even if you fund a Roth 401(k), your employer contributions are made in Traditional funds (at least until 2024).
So, unless you’ve converted all of your tax-deferred investments into After-Tax investments (which would have required a lot of liquid cash from a Taxable space), you probably have at least some money in all three of these asset locations.
The best approach is to get as much of your assets into After-Tax spaces as possible. To do this, you’ll need some balance in all three accounts.
You’ll need 1) tax-deferred funds to move, 2) Taxable funds to cover taxes for the conversions, and 3) a Roth account to put them in.
It will also be helpful to build up savings in Taxable investments over time in case you want to tap a large portion of funds for a large purchase like a home, car, or vacation before turning 59.5 when early withdrawal penalties are no longer an obstacle.
I don’t like being vague but like many financial choices, the right mix depends on your personal situation and goals.
What I can tell you is After-Tax funds are best at the time of withdrawal, but Taxable funds provide very helpful liquidity and tax-deferred investments can spare you from a big tax hit in high-income years.
Know your situation. Understand the tax issues. Make the best choice you can.
Won’t I Have to Withdraw my Tax-Deferred Funds Anyway?
Maybe.
I hear this question a lot when this topic comes up, so I thought it would be worthwhile to address it.
When choosing between withdrawals from your Taxable or tax-deferred investments, you may wonder what difference it makes if RMDs are going to force you to tap your tax-deferred accounts anyway?
To begin, RMDs will never force you to remove every penny from your tax-deferred accounts.
To be sure, the longer you live, the more your Tax-deferred accounts will be subject to RMDs.
But who knows how long you’ll live? And if you don’t have to realize taxes on the assets, why would you want to, even for a small amount?
Also, you can mitigate the tax sting from tax-deferred accounts through Qualified Charitable Distributions, so give those a look when you have time.
The only case I can see for taking a less tax-efficient approach for yourself is to spare your heirs from RMDs and related taxes.
Considering Your Estate
We wrote a post a few weeks back about the 10 best assets to leave to your heirs. All of these accounts appear on that list.
In summary, Roth accounts are best to inherit because the heirs can continue to allow the earnings to grow After-Tax until they are required to completely remove all of the funds 10 years after inheriting the account.
Next, Taxable assets receive a free step-up in basis meaning any earnings can be inherited After-Tax, but earnings realized after the date of the deceased’s death will be taxable.
Finally, tax-deferred assets are subject to RMDs and a 10-year complete forced liquidation after they are inherited. Every cent is subject to tax.
If you care about the potential tax liability for your heirs, this could impact your decision-making about how you make withdrawals.
Remember though, this is your money. You should take care of yourself first to ensure you can live the rest of your life without worrying about running out of money.
I have heard more than one tragic story about elderly people who bankrupted themselves trying to accommodate their heirs as much as possible.
Usually, they end up living longer than expected but made decisions based on a short remaining life expectancy.
Put on your oxygen mask first, won’t you?
