Asset Location: Putting Your Money in the Right Place

Where you put your money is key. Diversification is important, but where you hold those different assets can be even more important.

What is Asset Location?

Asset location is about strategically placing your investments across different types of accounts to minimize taxes. Don’t just think about stocks versus bonds. Think about where those investments are held.

You might assume that a 70/30 allocation (70% stocks, 30% bonds) should be applied equally across your Roth IRA, 401(k), and taxable brokerage account. But that’s not always the most tax-efficient approach.

Three Key Account Types

Consider these three main account types when thinking about asset location:

• Roth IRA (or Roth 401(k))
• Tax-Deferred Account (401(k), Traditional IRA)
• Taxable Brokerage Account

Each has its own tax advantages and disadvantages, making them suitable for different types of investments.

Roth IRA: Pedal to the Metal

Your Roth IRA should be your “pedal to the metal” account. Why? It offers tax-deferred growth and, potentially, tax-free withdrawals in retirement. It’s also ideal to die with this account.

• Growth-focused investments belong in your Roth. These are assets you expect to appreciate significantly over time.
• Equities that produce income could also go here. If you have stocks that pay dividends, your Roth can shield that income from taxes.

A Roth IRA is best for your most aggressive (When we say “aggressive,” we mean stocks, don’t get too crazy here 😉) investments.

Tax-Deferred Accounts: Shielding Taxes

Tax-deferred accounts, like 401(k)s and traditional IRAs, allow you to shield your money from taxes while it grows.

• Bonds are often a good fit for tax-deferred accounts. Bonds generate income, which is tax-deferred in these accounts.
• Important Note: Don’t put municipal bonds in these accounts. Municipal bonds are already tax-exempt, so you won’t get any additional benefit from holding them in a tax-deferred account.
• This is a good spot for income-producing assets and dividends.

These accounts are perfect for assets that generate taxable income, as they delay taxation until withdrawal.

Taxable Brokerage Account: Tax Efficiency

Your taxable brokerage account doesn’t offer the same tax advantages as Roth or tax-deferred accounts. Therefore, it’s not ideal for income-producing assets.

• Index funds are a good fit due to their tax efficiency. Index funds typically have low turnover, which minimizes capital gains taxes.
• Municipal bonds are a good choice if you’re a high-income earner. Municipal bonds provide tax-exempt income, which can be valuable if you’re in a high tax bracket.

Use this account for investments that generate minimal taxable income and benefit from long-term capital gains rates.

Revisiting the 70/30 Example

Instead of applying a 70/30 split across all accounts, consider this:

• Hold the bulk of your equity assets in your Roth IRA.
• Keep your conservative/bond assets in your 401(k) or traditional IRA.
• Use your taxable account for index funds and, if applicable, municipal bonds.

Things won’t always be perfect.

1. Your tax-deferred accounts are likely to be your largest holding, because this is where most people put their money throughout their careers.
2. Roth accounts are likely to be smaller until you do Roth conversions (more on this later).

The key is to optimize your asset allocation across all accounts to minimize your overall tax burden.

Final Thoughts on Asset Location

Asset location is a tax-efficient way to approach retirement. By strategically placing your investments, you can reduce your tax liability and keep more of your wealth.

Withdrawal Sequencing: The Order Matters

How you take money out of your accounts matters. The order in which you tap into your retirement savings can have a big impact on your taxes and the longevity of your nest egg. You are now taking money out of your accounts instead of putting money in.

Starting with Taxable Accounts

Your taxable brokerage account is usually the first place to start taking withdrawals.

• Ideally, you’ll only pay capital gains taxes, which are typically lower than ordinary income tax rates.
• Keep your taxable income low, which will help with Roth conversions. By using these funds first, you can control your tax bracket and make Roth conversions more effective.

This approach allows you to minimize your tax liability in the early years of retirement.

The Ideal Scenario (But Never This Easy)

Imagine having three perfectly filled buckets: pre-tax assets (401(k), IRA), after-tax assets (Roth IRA), and taxable accounts.

Never this easy, right? But sequencing matters.

• Sequencing matters in this scenario because you want to be as tax-efficient as possible.

A well-planned withdrawal strategy can help you stretch your savings further.

Moving to Tax-Deferred Accounts

Once your taxable account is winding down, move to your tax-deferred accounts (IRAs, 401(k)s).

• Rolling 401(k)s into an IRA is common at retirement. This can give you more control over your investments and lower fees.
• These withdrawals will be taxable income, so it’s essential to plan accordingly.
• Don’t forget about Required Minimum Distributions (RMDs) at age 75, which will affect Roth conversions. RMDs can push you into a higher tax bracket, so it’s important to factor them into your withdrawal strategy.

Withdrawals from these accounts are taxed as ordinary income, so it’s crucial to consider the tax implications.

Tax-Deferred Benefits

This bucket grows tax-deferred, so you still get tax benefits down the line as it starts to grow.

• Remember that you will eventually have to pay taxes on the withdrawals.

Saving the Roth for Last

Save your Roth accounts for last.

• Consider using Roth funds earlier if you’re near an income threshold (e.g., IRMAA brackets). Strategic Roth withdrawals can help you stay below certain income thresholds and avoid higher Medicare premiums.
• Gives you tax-free income to work with. This can be especially valuable in years where you have unexpected expenses or want to make a large purchase.
• Ideally, push most of it to the very end. The longer your money grows tax-free in a Roth account, the better.
• Dying with a Roth is great because it passes entirely tax-free to your heirs, which can be a significant benefit for your loved ones.

Roth accounts offer tax-free withdrawals in retirement, making them the most valuable asset to preserve.

Withdrawal Sequencing is Important

Withdrawal sequencing is important, and everyone’s situation will be unique.

• The plan of attack might be based on your buckets, goals, and strategies. Are you trying to fund a lavish lifestyle, or are you trying to preserve your assets for future generations?

A personalized withdrawal strategy is essential for maximizing your retirement income and minimizing taxes.

Roth Conversions: Locking in Lower Tax Rates

The Roth conversion is one of the largest tax-saving strategies. It allows you to move pre-tax money into a Roth account, where it can grow tax-free and be withdrawn tax-free in retirement.

Important Consideration

Before diving in, it’s important to note that a Roth conversion might not be right for everyone. 

Locking in Lower Tax Rates

Lock in lower tax rates for the given year. By paying taxes on the converted amount now, you can avoid potentially higher tax rates in the future.

What is a Roth Conversion?

A Roth conversion is taking pre-tax dollars (IRA, 401(k)) and converting them to a Roth, creating a tax bill on purpose.

Is this crazy? Not at all. You are purposefully paying income taxes today on money that was tax-deferred.

Filling Up Lower Tax Brackets

You’re trying to fill up those lower tax brackets (10%, 12%, up to 20%). The goal is to convert enough money each year to take advantage of the lower tax brackets without pushing yourself into a higher bracket.

The Problem with Pre-Tax Dollars

Because a lot of high-income earners save so much money, their pretax dollars are probably very high, leading to RMDs, which will cause higher incomes in retirement than when they were working. RMDs can force you to withdraw more money than you need, pushing you into a higher tax bracket.

The Roth Conversion Strategy

Roth conversions are trying to fill the tax brackets from the lower tax brackets from the day you retire or maybe slow your income by a good margin to when those RMDs really start. By converting pre-tax money to a Roth, you reduce the amount subject to RMDs in the future.

Knowing Your Tax Bill

Know your tax bill in a given year by working with a tax planner and financial advisor. A professional can help you determine the optimal amount to convert each year, taking into account your current income, tax bracket, and future RMDs.

• If doing conversions later in the year, make quarterly payments to avoid underpayment penalties.
• Tip: Don’t forget to make estimated tax payments to cover the tax liability from the conversion.

Planning is key!

Lowering Future RMDs

By converting pre-tax dollars, you lower your future RMDs. These RMDs are based on your 12/31 pre-tax balance. A lower pre-tax balance means lower RMDs and less taxable income in retirement.

Power of Roth Conversions

The conversions are powerful because you can control the tax narrative. You can proactively manage your tax liability and create a more tax-efficient retirement income stream.

Largest Tax Savings

Roth conversions are one of the largest tax savings for new clients. Many people overlook this strategy, but it can have a significant impact on your retirement savings.

Golden Window for Roth Conversions

The window from when you retire to when the RMDs start is the golden window for these Roth conversions. Take advantage of this period to convert as much as possible to a Roth account.

3 Strategies to Consider Before Retirement

Here’s a quick recap:

• Asset location
• Withdrawal sequencing
• Roth conversions

These three strategies are very effective when you are preparing for retirement.

Consider this a starting point! You have the power to take control of your financial future.