Using the Resource Location to Defuse a Retirement Tax Bomb

Editor’s Note: This is part six in a seven part series. It dives deeper into the second strategy to defuse a retirement tax bomb by implementing asset tracking. If you missed the introductory article, you may find it helpful to get started here.

Most investors have heard of asset allocation, but asset location is another story and could help investors with large tax-deferred savings reduce their taxes in retirement.

Allocation of assets refers to how a portfolio is allocated to various asset classes that have different historical investment returns and standard deviations. The simplest example is an equity allocation, such as a 60% equity and 40% bond allocation, which is a common allocation for retirees. But there are also dozens of more granular asset classes that can be managed, for example, large cap American stocks or small cap international stocks. Asset allocation is essential to effectively diversify the portfolio and reduce risk.

Good Position it’s a different portfolio management strategy – one that few clients I meet have heard of. Few financial advisors implement it as well. Resource location seeks to minimize taxes by placing different asset classes into specific tax segments (taxable, pre-tax, tax-free).

Put resource localization into practice

In a nutshell, here’s how the asset location works:

  • Typically, you want to place investments with low expected returns, such as bonds, in tax deferred accounts.
  • Place investments with high expected returns, such as small-value or emerging market equities, in tax-free Roth accounts.
  • Place stocks that have most of their return on investment from capital appreciation (which are taxed at lower long-term rates of return) into taxable accounts.

Asset location can increase after-tax returns because your deferred tax accounts will grow more slowly (and so will your future tax liability), while your tax-free accounts will grow more.

However, it can be difficult to implement because each investor’s situation is different and can have different combinations of taxable, deferred and tax-free investments. It can be further complicated by mutual funds or ETF holdings that merge different asset classes, such as a growth and income fund or a target date fund, which would typically implement a 60% stock and 40% allocation. % of bonds. To implement asset tracking effectively, you want investments that are very “pure asset classes”, so you are sure you have asset classes in the right tax buckets.

What resource location can do for you

Let’s look at a simple example of the location of the asset, using the 40-year pair from previous articles in this series. They have a portfolio of $ 500,000, except this time we’re assuming it’s 50% pre-tax and 50% Roth, and they want a combined 70% equity and 30% bond asset allocation. For simplicity, I will not assume any further contributions in this example.

Scenario one: no attempt to locate the resource

Assume the same 70-30 allocation is implemented in both pre-tax and Roth accounts, which means that the resource position is not optimized. I see this often, even from consultants who allegedly offer fiduciary managed accounts. The mixed annual return in each account would be 8.5%, and after 25 years, the couple would have $ 2.15 million in the pre-tax account and $ 2.15 million in the tax-free Roth account as they retire.

Scenario two: put asset location into operation

The same pre-tax and Roth balance is assumed, but this time asset tracking is implemented. The tax deferred account holds 100% of the bonds ($ 150,000) and $ 100,000 worth of stock. Meanwhile, the Roth account holds 100% stock ($ 250,000). It is the same overall 70-30 allocation, which means the same aggregate risk and expected return of 8.5%. But after 25 years, the deferred tax account grows to just $ 1.6 million (26% less), while the tax-free Roth account grows to $ 2.7 million (26% more). This makes a huge difference in the tax liability the couple will face in retirement.

The final article in this series of retirement tax bombs will examine the third strategy for defusing a retirement tax bomb, Roth conversions.

Partner, Financial Management Forum

David McClellan is a partner of Forum Financial Management, LP, a registered investment advisor who manages more than $ 7 billion in client assets. He is also VP and Head of Wealth Management Solutions at AiVante, a technology company that uses artificial intelligence to predict lifelong medical expenses. Previously David spent nearly 15 years in executive roles with Morningstar (where he designed retirement income planning software) and Pershing. David is based in Austin, Texas but works with clients nationwide. His practice focuses on financial life coaching and retirement planning. He often helps clients assess and defuse retirement tax bombs.

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