Asset Location: The Missing Piece in Your Investment Puzzle?

Asset Location: The Missing Piece in Your Investment Puzzle?

When it comes to managing your investments, the term “diversification” probably rings a bell. It’s one of those golden rules of personal finance: don’t put all your eggs in one basket. Most of us understand that spreading your investments across different asset classes—stocks, bonds, real estate, and so on—helps reduce risk.

But what about where you hold those assets? This is where asset location comes into play, and it’s just as crucial, yet far less understood.

Asset location refers to the type of account that holds your investments, whether that’s a pre-tax account (like a Traditional 401(k) or IRA), a post-tax account (such as a Roth IRA), or a taxable brokerage account. Believe it or not, the account type can have just as much impact on your financial future as the investments themselves.

Even if you’re not currently in a position to invest across all three account types, it is still helpful to identify the opportunities or constraints that may impact you now and in the future. Your Peak team is available to help you understand how this all affects your unique situation.

So, let’s dive into why asset location is so important and how to structure your portfolio for maximum tax efficiency and flexibility.

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How Asset Location Can Impact Your Bottom Line

First, a quick definition: asset location is the strategy of placing investments in specific account types to optimize your tax situation. Different accounts are taxed differently and knowing which investments to hold in which account can save you a significant amount of money over time.

Here’s why this matters: when you retire, you’ll likely be withdrawing money from multiple accounts. The tax implications of these withdrawals can vary widely depending on how your investments were set up. If all your money is in one type of account—say, a Traditional IRA—you might find yourself facing some unexpected (and unpleasant) surprises in the form of a hefty tax bill. On the flip side, if you’ve strategically placed your assets across pre-tax, post-tax, and taxable accounts, you’ll have far more control over how much tax you pay in retirement.

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The Three Buckets of Asset Location

To understand asset location, let’s break it down into three main “buckets” of accounts:

1. Pre-Tax Accounts

These include Traditional 401(k)s, 403(b)s, and Traditional IRAs. Contributions to these accounts are made with pre-tax dollars, meaning you get a tax deduction today, but withdrawals in retirement are fully taxable as ordinary income. The main benefit? An upfront tax deduction and tax-deferred growth. Every dollar your investments earn stays in the account, compounding without being reduced by taxes—at least until you withdraw funds.

The downside? When you withdraw money in retirement, it is taxed as ordinary income, which could push you into a higher tax bracket. And let’s not forget about Required Minimum Distributions (RMDs), which force you to start withdrawing—and paying taxes on—your money starting at age 73 (for most people). If you have a substantial balance in these accounts, RMDs can create a tax headache by forcing you to withdraw and pay taxes on funds you don’t necessarily require to cover your cash flow needs.

2. Post-Tax Accounts

Roth IRAs and Roth 401(k)s fall into this category. With these accounts, you contribute after-tax dollars, meaning you don’t get a tax deduction today. However, qualified withdrawals in retirement are 100% tax-free—yes, including the earnings growth!

The downside? There are no immediate tax benefits when you contribute. And while Roth IRAs have no RMDs, Roth 401(k)s do (though you can roll your Roth 401(k) into a Roth IRA to avoid them).

The beauty of post-tax accounts is their tax-free growth and withdrawal benefits. In retirement, being able to tap into a tax-free account can make a significant difference in managing your year-to-year tax liability.

3. Taxable Accounts

These are your standard brokerage or investment accounts. There’s no tax advantage when you contribute, but they offer flexibility that the other two buckets don’t. You can withdraw money at any time, for any reason, without penalty. Additionally, you can benefit from reduced tax rates, as long-term capital gains are taxed at lower rates than ordinary income. In fact, if your income is low enough, you can even take advantage of a 0% capital gains rate.

The downside? You’ll pay taxes on dividends, interest, and capital gains as the account grows, even if you aren’t taking distributions or withdrawals.

Taxable accounts are incredibly versatile. Need to fund a big expense before retirement? No problem. Want to minimize taxes in retirement by strategically realizing capital gains? Totally doable.

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Why All Three Buckets Can Be Beneficial

If you’re thinking, “Can’t I just pick one bucket and call it a day?”—hang tight for a second. Each bucket has unique benefits and drawbacks, and the real magic happens when you combine them strategically.

Here’s why you may benefit from a mix of pre-tax, post-tax, and taxable accounts:

1. Tax Flexibility in Retirement Imagine you’re retired and need $180,000 for living expenses. If all your money is in a Traditional IRA, every dollar you withdraw will be taxed as ordinary income. But if you can pull $90,000 from a Roth IRA (tax-free) and $90,000 from your Traditional IRA, you’ll stay in a lower tax bracket and likely pay far less in taxes overall.

2. Protection Against Tax Law Changes The Tax Cuts and Jobs Act (TCJA) expires in 2025; who knows what tax rates will look like after that? By having money in all three buckets, you’re hedging against future tax changes. If rates go up, you can rely more on your Roth IRA. If they stay the same, your Traditional IRA might still be the best bet.

3. RMD Management Having funds in taxable and Roth accounts allows you to reduce RMDs from pre-tax accounts, which can help control your taxable income in retirement.

4. Estate Planning Advantages Roth accounts can be a powerful tool for leaving a tax-free inheritance to your loved ones, while taxable accounts often benefit from a step-up in basis for heirs.

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How to Build Your Three-Bucket Strategy

So, how do you make sure you’ve got money in all three buckets? Here are some steps to consider:

1. Maximize Employer Matches

If your employer offers a pre-tax 401(k) match, prioritize contributions to your 401(k) up to the match. This is free money—don’t leave it on the table.

2. Diversify Contributions

After getting your employer match, consider splitting additional savings contributions between a Roth 401(k) (if your employer offers the option) or Roth IRA and a taxable account. If your income is too high for a Roth IRA, look into a backdoor Roth contribution.

3. Be Strategic About Roth Conversions

If you have a large balance in pre-tax accounts, think about converting some of that money to a Roth IRA. This involves paying taxes now to avoid paying them later. It’s especially effective in years when your income is lower, like early retirement or a sabbatical.

4. Invest Tax-Efficiently

In taxable accounts, prioritize tax-efficient investments like index funds, ETFs, and municipal bonds. Reserve tax-inefficient investments, like fixed income and high-yield bonds, for tax-advantaged accounts.

5. Reassess Regularly

Your financial situation and tax laws will change over time, so it’s important to revisit your asset location strategy periodically.

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The Bottom Line

Asset diversification gets all the attention, but asset location is just as important—if not more so—when it comes to maximizing your financial success. By spreading your investments across pre-tax, post-tax, and taxable accounts, you’ll gain the flexibility to manage your taxes effectively, adapt to future tax law changes, and help make your money last longer in retirement.

So, take a moment to review your current portfolio. Are you leaning too heavily on one bucket? If so, it might be time to rethink your strategy and start building a more balanced approach.

Remember, taxes may not be the most exciting topic, but getting them right can mean the difference between a comfortable retirement and one that’s taxing—pun intended.

 

Advisory Services offered through Peak Asset Management, LLC, an SEC registered investment advisor. The opinions expressed and material provided are for general information, and they should not be considered a solicitation for the purchase or sale of any security. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation. This content is developed from sources believed to be providing accurate information and may have been developed and produced by a third party to provide information on a topic that may be of interest. This third party is not affiliated with Peak Asset Management.  It is not our intention to state or imply in any manner that past results are an indication of future performance. Copyright © 2024 Peak Asset Management