Taxes Matter In Retirement (Part II)
Last week, I discussed why tax diversification matters in retirement. In it, I described how we tend not to think of tax treatment in distribution as we build our wealth. Instead, we place most of our wealth in accounts that are taxable as income (IRAs, 401(k)s) and in our homes (equity.)
But in retirement, we may want to finesse how much income we show year-over-year in order to take advantage of the tax code; because having assets with different tax treatments (capital gains, Roth, deferred) provides more choices, which lead to (potentially) paying less tax out of your savings.
Today, I want to turn to the second area where taxes matter in retirement; that is, making the best use of the types of taxes investments create. It’s important to think of the diversification or asset allocation of your portfolio in its entirety when assessing its health and balance. (It’s so important that I will have a separate post on diversified portfolios in the near future.) Maybe you have an overall 60/40 or 55/45 allocation of stocks to bonds. But it’s handy and efficient to think about how certain investments, due to their tax treatment, affect the growth of a portfolio. This “type-of-tax” finessing is called asset location.
For example, you want your Roth account to grow as large as possible for as long as possible. If your portfolio holds 25% growth stocks, those growth stocks and growth funds likely belong in your Roth account.
However, if you hold bonds and bond funds, those dividends are treated as income, and since everything in your traditional account is also treated as income, they belong in your traditional IRA/401(k) account.
Your non-qualified account may contain municipal bonds (which are largely tax-free) and growth stocks (which do not pay a dividend). If you have blue chip stocks that do pay a dividend, once again, they belong in your Roth or traditional IRA/401(k) account.
Today, I might have three accounts that compose my $1,000,000 nest egg:
Roth Account: $100,000; Asset Allocation (stocks/bonds) 60/40
Traditional Account: $900,000; Asset Allocation (stocks/bonds) 60/40
Overall Account: $1,000,000, Asset Allocation (stocks/bonds) 60/40
When you’re smart about asset location (and of course you are!) it can improve your tax efficiency, but it may also skew your asset allocation. For example:
Roth Account: $100,000; Asset Allocation (stocks/bonds) 90/10
Traditional Account: $900,000; Asset Allocation (stocks/bonds) 55/45
Overall Account: $1,000,000, Asset Allocation (stocks/bonds) 60/40*
* Rounded
In the end, your asset allocation hasn’t changed. But you’ve rearranged your investments to optimize growth and taxes. And every bit of tax benefit helps.
So, over the past two blogs I’ve provided a solid base of information on tax diversification and asset location.
The short story: I recommend that you have more than one tax treatment by the time you retire.
I’m thinking a blog isn’t the best way to articulate these ideas and all the terminology and twists they contain. Admittedly, we can get into the weeds quickly, and I’ll work on developing more and better ways to communicate them to you. For now, know that your job is to ensure that your financial advisor is thinking about these things on your behalf. Or, if you’re a DIYer, take a deeper dive into your portfolio with this in mind.
Last, bookmark these two blogs for next tax season and celebrate your steps toward tax diversification and asset location. They will pay dividends down the road. #WeRescueOurselves
Copyright © Madrina Molly, LLC 2024. All rights reserved.
The information contained herein and shared by Madrina Molly™ constitutes financial education and not investment or financial advice
Sherry Finkel Murphy, CFP®, RICP®, ChFC®, is the Founder and CEO of Madrina Molly, LLC.
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