Pay Less Tax in Retirement: Why Strategic Asset Location is So Important

We all love paying less tax—especially if you're retired. But did you know that one of the best ways to reduce your tax bill is through strategic asset location?

You're likely familiar with asset allocation—the mix of stocks, bonds, and cash that reflects your risk tolerance and investment goals. Strategic asset location takes that a step further by owning certain assets in the most tax-efficient account. If done effectively, this strategy could potentially save you tens of thousands of dollars in tax over the course of your retirement.

The Three Tax Buckets (Your Retirement Superheroes)

Most people shift from accumulating assets to withdrawing funds in retirement, making tax-efficient withdrawals essential. Successful asset location starts by understanding your assets in three main "buckets," each with its own "superpower."

The Basic Principle of Strategic Asset Location

The core principle is simple: Put the most tax-inefficient assets into your tax-sheltered accounts while placing tax-efficient assets in your taxable accounts.

• In Tax-Deferred Accounts (Traditional IRA/401k): These are the ideal home for tax-inefficient assets.

  • Example: Real Estate Investment Trusts (REITs) are notorious for non-qualified dividends, which are taxed at your highest ordinary income rate. By holding REITs here, you defer that immediate tax hit.

• In Tax-Free Accounts (Roth IRA/401k): These accounts offer superior growth potential because the growth and distributions are tax-free. 

  • Recommendation: Investing these accounts primarily in diversified equities (stocks) will typically deliver the most favorable long-term outcome

Common Asset Location Blunders

Many retirees hold the wrong investments in the wrong buckets, which can lead to significant "tax drag". Here are three mistakes we commonly see:

1. Placing Tax-Deferred Funds in an Annuity: This is redundant, as you're putting a tax-deferred account inside an existing tax-deferred vehicle. It often adds extra layers of fees and limits liquidity.

2. Holding Bonds in a Roth IRA (for those far from retirement): Because Roth IRAs offer tax-free growth, you want your highest-growth assets (like diversified equities) in them. Bonds generally offer lower growth potential.

3. Holding Tax-Free Municipal Bonds in an IRA Account: This is a massive blunder. Municipal bonds are already tax-free at the federal level. Putting them in a tax-deferred IRA adds no benefit, but when the money is withdrawn from the IRA, it is then taxed as ordinary income.

Asset Location is a Two-Step Process

Capturing the full benefits of asset location requires a two-step approach:

Step 1: Getting the Right Assets in the Right Bucket

This is the strategic placement discussed above—ensuring tax-inefficient assets are in tax-sheltered accounts.

Step 2: The Withdrawal Strategy

In retirement, your withdrawal strategy—the sequence in which you pull money from your three buckets—is your most powerful tool for tax minimization. A truly effective strategy involves taking money from the right accounts, with the right assets, in the right order.

By carefully coordinating distributions from your Taxable and Tax-Deferred (IRA) accounts, a good planner can help:

• Manage your Adjusted Gross Income (AGI) to keep you in lower tax brackets.

• Minimize expensive Medicare IRMAA surcharges.

• Maximize deductions that are subject to income phaseouts.

That's a tax saving triple play! Your retirement plan should be reviewed in detail each year to adjust for market returns, changes in the tax code, and your personal cash flow needs.A great investment portfolio is just the start; you need a strategy that coordinates your three account types to work in unison as part of a single, tax-management machine. That’s the true power of asset location and a well-executed withdrawal plan.