Tax efficiency in retirement is a nuanced process that requires a great deal of planning and finesse to get right. Taxes are an area where many retirees struggle. With changing cash flow, tax brackets, and investment strategies, tax-efficiency becomes an important part of a retiree’s financial picture.
Here at TFS, we know the impact that taxes can have on your retirement income and seek to help our clients implement the strategy that can put them in the best tax position possible. In order to do this, there are two investment strategies you need to understand:
- Asset location
- Asset allocation
Even though their names are only 2 letters apart, these two strategies work both independently and together in order to help increase the tax-efficiency of your investments. Today, we are going to take a look at each of these strategies individually and also show how much stronger they can be together.
The basics of asset location
Asset location is an investment strategy that seeks to optimize return by placing certain asset classes in corresponding investment accounts with the most favorable tax treatment.
You can think about this like food placement in a grocery store. If the peppers are in the produce aisle, they will have a better chance of being sold as opposed to if they were stored in the dairy aisle. By placing the peppers in the produce section, you make the product easier to find, decrease the chance of rot, and increase potential sales. Now, let’s take this idea back to its role in investments.
We have two aspects at play here:
- The investments themselves
- Where the investments are stored
Both of these ideas are part of asset location.
Certain asset classes have the potential to perform better in different investment accounts.
Some popular examples of different asset classes are found below.
- Mutual Funds
- Real estate
When looking at the potential accounts to house these securities in, there are three main options:
- Tax-deferred (401k, Traditional IRA)
- Tax-free (Roth IRA, Roth 401k)
- Taxable (Investment account, brokerage account)
Each asset class has a different level of tax-efficiency associated with it, meaning some assets are more tax-efficient than others. This tax-efficiency scale can help give a window into the options for the best placement.
Let’s use the individual stock as an example. In general, stocks are relatively tax-efficient. This is especially true if they are held past a year, making the proceeds from the sale eligible for long-term capital gains tax which is often much more favorable than ordinary income tax.
We have now established the investment itself, which is the stock. Now, we need to move on to the second point where the investment is stored. As a general rule of thumb, tax-efficient assets often perform best in taxable accounts. A taxable account simply means that the investor must pay taxes on the investment income in the year it was received.
Conversely, a bond is a relatively tax-inefficient asset, namely due to the ordinary income tax bill on all interest payments. For this tax-inefficient asset, placing it in a Roth account will allow you to take advantage of the tax-free growth. By doing this, you wouldn’t need to pay taxes on the interest from the bond, rather you only pay taxes on the money you used to buy the bond.
Asset location is a nuanced process and each investor’s strategy should be tailored to their unique portfolio. These examples represent general trends so if you would like specific advice tailored to you, be sure to set up an appointment.
Now that you have a good grasp on asset location, let’s move on to asset allocation.
The basics of asset allocation
While asset location is concerned with the tax-efficiency and placement of each security in your portfolio, asset allocation takes a broader look at your portfolio and how it functions to suit your needs, risk tolerance, and goals.
The objective of asset allocation is to balance your portfolio with an appropriate division of securities with the goal of improving your financial strategy. Without proper asset allocation, your investment portfolio may not have the risk profile or mix of investments you need.
This investment strategy takes a bird-eye look at your portfolio by diving your resources to different asset classes in order to achieve the right balance between risk and reward. In general, the three most popular types of asset classes are:
Asset allocation will help determine in what security you should put more of your resources.
In order to find the right asset allocation strategy for you, consider the following factors:
- Your risk tolerance
- Your investment goals
- Your investing timeline
If, for example, you have a long investing timeline, you may be more aggressive and risky in the asset classes you choose like favoring stocks and putting less attention on bonds. Whereas if you have a shorter investment timeline, your risk might decrease and you may change how you fund those assets. Your timeline is unique to you and your needs.
Asset allocation is dependent upon the investor and is an important benchmark for your portfolio. This strategy can help you think through the goals that you have and how to best use your resources in order to achieve those goals. Asset allocation does not guarantee a profit nor does it protect against a loss in a declining market.
Remember, this is simply a general overview of asset allocation. In order to get a full sense of what it could mean for your investment strategy, make an appointment with us.
Two is better than one
Investments are an important part of your financial plan both to and through retirement. When you retire, that doesn’t mean your investing days come to an end. Many people want to invest through their golden years so it is important to make a plan that will complement your new investing goals and coupling asset location and asset allocation is a great start.
Each of these investment strategies is crucial to compiling the right portfolio for your needs and goals as they evolve. Asset location is concerned with the tax implications of the individual securities in your portfolio while asset allocation helps assemble and divide the resources in your portfolio on a higher level.
Implementing both into your investment strategy will not only give you more tax-efficient investments, but it will also help you create a balanced portfolio aligned with your risk, goals, and unique timeline.
Asset location and asset allocation comprise just a fraction of the lenses that we use to manage our clients’ investments. Our comprehensive philosophy takes these and many other strategies to help our clients create a portfolio that is truly reflective of their goals.
We are passionate about helping our clients establish a well-rounded investment portfolio, tailored to their needs. Are you interested to learn how asset location and asset allocation could transform your portfolio? Give us a call. We can’t wait to hear from you.