Asset Location - Why you need to be invest different in each of your three accounts
This is part three in this series that started with:
Followed by:
I would encourage you to read the first two articles to give further context behind today's article.
Before we start, let's recap a few concepts that are important to understand for this article.
1) Since investing is a long term plan and we assume that your invested money will grow over time, we're going to call the money you invest today the Small Dollar.
We'll call your future invested money the Larger Dollar.
Today
30 years from Today
2) Beyond simply just saving and investing, it is extremely powerful to focus on your Tax Liability. Both now and in the future.
3) You have many accounts that you can save in, but they fall into three main categories.
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Pre-Tax
-
Post-Tax
-
Taxable
Pre-Tax - you pay taxes LATER
(the larger dollar)
Post-Tax - you pay taxes NOW
(the smaller dollar)
Taxable - you pay taxes LATER
(only on gains)
Knowing this information, it is very important to invest each of these three accounts different.
Let's look at an example
This couple is invested in roughly a 70/30 portfolio. (70% stocks, 30% bonds. )
With any portfolio, this 70/30 mix of stocks and bonds is broken down into more detailed "asset classes."
These asset classes all behave different in different market conditions.
They also grow at varying expected rates of return.
Understanding this will help you understand why each of the three types of accounts should have different investments.
Pre-Tax
-
You pay taxes LATER, on the LARGER dollar.
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You are REQUIRED to withdraw funds when you reach age 72.
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These Withdrawals are FULLY TAXABLE.
Post-Tax
-
You pay taxes NOW, on the SMALLER Dollar.
-
You are NEVER required to withdraw money.
-
Any withdrawals are TAX FREE.
Taxable
-
You pay taxes on the GAINS.
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You are NEVER required to withdraw money.
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Only Gains are taxed, and at a PREFERRED RATE.
This means you should invest your:
Pre-Tax
Slow Growth (bonds)
Or
Tax INEFFICIENT
Post-Tax
High Growth (stocks)
Or
Tax INEFFICIENT
Taxable
High Growth
Or
Tax EFFICIENT
What this looks like in real life
Let's break down the most common asset classes.
Asset Class | Growth | Tax Efficiency | Optimal Account |
|---|---|---|---|
Sector / Specialty | High | Low | Post-Tax |
Municipal Bond | Low | High | Taxable |
US Bond | Low | Low | Pre-Tax |
World Bond | Low | Low | Pre-Tax |
Real Estate | High | Low | Post-Tax |
Emerging Markets | High | Low | Post-Tax |
International | High | Mid/High | Taxable |
Mid/Small | High | Mid | Post-Tax |
Large Value | High | High | Taxable |
Large Growth | High | Mid/High | Taxable |
Why all of this matters...
More important than how much money you make investing is, how much you keep.
If you're (lucky, wise, diligent) enough to be a high cash flow saver, you most likely have two or maybe all three types of accounts we've talked about.
Implementing a proper asset location investing strategy is proven to leave you with more money net of taxes over time. 1
Beyond just having more money net of taxes, I believe we often overlook the power behind having the flexibility and control (of your taxes) that is provided by investing into all three types of accounts.
During your 30's, 40's & 50's, your accounts grow... (hypothetical numbers for illustration)
Pre-Tax
6%
Post-Tax
8%
Taxable
7%
When you're in your 60's or 70's
Pre-Tax
Since your expected growth was lower, this account will be smaller.
This LESSENS your Required Distributions giving you MORE CONTROL of your taxes.
Post-Tax
Since we want to MAXIMIZE your Tax Free money, higher (expected) growth investments held in this account should (hopefully) mean a larger balance.
Taxable
You can use funds from this account for income while doing Partial Roth Conversions.
Or just to keep taxable income low.
When you're in your 80's or 90's
Pre-Tax
You will have been taking Required Minimum Distributions from this account.
Meaning the balance could be relatively small.
Post-Tax
Potentially, you've never touched this money so this account has continued to grow.
Taxable
You may have used most of these funds to live off of early in retirement while doing Partial Roth Conversions.
Or, you may still have a large balance here.
Passing to Heirs
Pre-Tax
Your spouse can inherit this account and take it as their own.
Non-spousal beneficiaries will have to withdraw balance over 10 years.
FULLY TAXABLE TO THEM!
Post-Tax
Your spouse can inherit this account and take it as their own.
Non-spousal beneficiaries will have to withdraw balance over 10 years.
TAX FREE TO THEM!
Taxable
Your spouse can inherit this account and take it as their own.
Non-Spousal beneficiaries will receive the assets with a stepped up cost basis.
ESSENTIALLY TAX FREE!
Let's sum this all up:
Paying attention to proper Asset Location can:
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Give you more control of your taxes now and in the future.
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Provide you with a savings strategy that is flexible, giving you access to funds pre-retirement if needed.
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Allow you to implement some very powerful tax strategies post retirement which could potentially leave you with more money after taxes.
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Potentially leave more assets to heirs by leaving assets more tax efficiently.
NOTE: I've attempted to overly simplify this example. If it still seems a bit confusing, that is because it is a confusing subject.
This is an advanced financial planning strategy. One that can provide you with a lot of benefits long term.
This strategy is best when managed properly from the beginning.
If not managed properly, it can become much more complicated later in life to shift the investments properly because there are taxes involved.
If you're young, I recommend you consult (pay) a professional at least once per year to review your Asset Location balance.
If you're nearing retirement, I recommend you hire a professional who can effectively manage your investments and taxes.
If you are interested in learning more about Asset Location, but don't know how to get started feel free to schedule a phone call. We're happy to help...
We're a different kind of financial firm than you may be used to.
Disclaimer: The material and opinions provided in this document are meant for general illustration and/or informational purposes only and should not be construed as investment, tax, or legal advice for any individual. Although the information has been gathered from sources believed to be reliable, each reader must decide whether it is valid and applicable to his/her own unique circumstances. Any economic forecasts made in this commentary are merely opinion, and any referenced performance data is historical. As a result, neither is a guarantee of future results, as all investments involve risk.