Asset Location: The Missing Piece in Your Investment Puzzle?
When managing your investments, you’ve probably heard financial professionals and talking heads use the term “diversification” quite often. One of the easy ways to think of why you should diversify your assets is this: 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 the term asset location comes into play. It’s equally important as diversification, yet far less understood or discussed.
In this blog, our team of Boulder CFP ® professionals discusses the importance of constructing well-diversified investment portfolios that consider asset location strategies to maximize return potential while minimizing tax exposure.
Understanding Asset Location
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 can’t 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. The Peak Asset Management team of Boulder financial advisors can help you understand how asset location may affect your unique situation.
How Asset Location Can Impact Your Bottom Line
First, here is a quick definition: asset location places 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 significant money over time.
This matters because you’ll likely be withdrawing money from multiple accounts when you retire. 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—a Traditional IRA—you might face 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.
The Three Buckets of Asset Location
To understand asset location, let’s break it down into three main “buckets” of accounts:
- 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.
Consider working with a financial planning firm in Boulder, such as Peak Asset Management, which can assist you in assessing your RMD exposure.
- Post-Tax Accounts
Roth IRAs and Roth 401(k)s fall into this category. You contribute after-tax dollars with these accounts, 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, tapping into a tax-free account can make a significant difference in managing your year-to-year tax liability.
- 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. You can use a 0% capital gains rate if your income is low enough.
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? It’s totally doable.
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; the magic happens when you combine them strategically.
Here’s why you may benefit from a mix of pre-tax, post-tax, and taxable accounts:
- Tax Flexibility in Retirement: Imagine you’re retired and need $180,000 for living expenses per year. 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.
- 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. Your Traditional IRA might still be the best bet if they stay the same.
- 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.
- 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.
- Due to the complex nature of managing your assets properly, the services of a Boulder investment advisor can be beneficial. If you don’t have the time or inclination to oversee your wealth, an investment advisor in Boulder can provide the financial and tax guidance you need.
How to Build Your Three-Bucket Strategy
So, how do you ensure you have money in all three buckets? Here are some steps to consider:
- 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.
- Diversify Contributions
After getting your employer match, consider splitting additional savings contributions between a Roth 401(k) (if your employer offers the option) or a Roth IRA and a taxable account. Consider a backdoor Roth contribution if your income is too high for a Roth IRA.
- Be Strategic About Roth Conversions
If you have a large pre-tax account balance, consider 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.
- 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.
- Reassess Regularly
Your financial situation and tax laws will likely change, so it’s important to revisit your asset location strategy periodically.
The Bottom Line
Asset diversification gets all the attention, but asset location is just as important—if not more so—for maximizing 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 build 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 taxing—pun intended.
Are you interested in learning more about asset location strategies for your wealth? Contact the Peak Asset Management team today.
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
