Are there investment strategies that take into consideration growth and taxation post-retirement?
One of the keys to maximizing growth and minimizing taxes in retirement is to pair the least tax-advantaged securities with the most tax-advantaged accounts. The point is to neutralize the immediate tax impact on your portfolio while still allowing for capital appreciation. To understand how to manage this kind of pairing, it’s important to understand two concepts: asset allocation and asset location.
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Why Asset Allocation Matters
Asset allocation is how you divide your money into different types of securities. The most well-known classes of assets are stocks and bonds. Within each asset classes are further divisions. For example, you can invest in small-cap stocks (small companies) or large-cap stocks (large companies), and bonds can be divided into categories based on the credit worthiness of the issuer.
Asset allocation matters because it reflects your desired trade-off between growth and safety. Stocks are more likely to grow, or experience capital appreciation, while bonds are normally safer but at the cost of less growth potential.
Besides striking a balance between capital appreciation and safety (or stability), asset allocation matters because of how securities are taxed. You pay either ordinary income taxes or capital gains taxes on investment returns, depending on the type of asset and how long you held it. Long-term capital gains rates are more favorable, with rates ranging from 0% to 23.8%.
Here are some common investments and how they’re taxed:
Municipal bonds: Interest income is not taxable at the federal level, and sometimes not taxable at the state and local levels.
Corporate bonds: Interest income is taxed at ordinary income rates at both the federal and state levels. Additional taxes apply if you sell before the bond’s maturity date.
Individual stocks or stock funds: Gains on investments held for less than a year are subject to ordinary income tax rates; gains on investments held for more than a year are subject to long-term capital gains rates.
ETFs: Designed for buy-and-hold investors, gains are usually subject to the more favorable long-term capital gains rate.
Actively managed funds: Managers tend to buy and sell regularly, triggering a less favorable short-term capital gains tax.
Real estate investment trusts: REITs must pay dividends annually, which are taxed as ordinary income.
Mutual funds: Usually paid annually and taxed as ordinary income.
Why Asset Location Matters
Once you’ve settled on an asset allocation that reflects your preferred balance between growth, safety and tax exposure, it’s time to consider asset location – that is, where those securities will live. Here are the three main types of investment accounts, as distinguished by their tax rules:
Taxable: A brokerage account at a bank or investment firm. You pay taxes annually on realized gains.
Tax-deferred: A retirement plan, such as a 401 (k) offered through your employer or a traditional IRA. Earnings will not trigger capital gains taxes as your balance grows. But withdrawals in retirement will be subject to ordinary income taxes.
Tax-exempt: A Roth IRA or Roth 401 (k) that’s funded with after-tax dollars. After you turn 59 and a half and have not funded the account for five years, you can withdraw contributions and earnings with no tax consequences.
From a tax perspective, Roth accounts seem like the clear winner. But there’s a place for each of the other two types of accounts – asset locations – in your investment portfolio. You do not want all your eggs in one basket, as they say.
As mentioned, the key to smart asset location is pairing the least tax-advantaged investments with the most tax-advantaged accounts. The point is to neutralize the immediate tax impact on your portfolio. What follows are three possible ways to pair asset allocation with asset location.
Putting it Together: Three Tax-Advantaged Investment Strategies
Firstly, an actively managed mutual fund with high turnover probably generates a lot of short-term capital gains. Holding the fund in a regular brokerage account means those gains will be taxed at ordinary income rates at the end of the tax year. If you hold the mutual fund in a traditional IRA, you do not pay any tax on your gains. This preserves your after-tax return, maximizing your growth potential in the years to come. Eventually you’ll pay ordinary income tax on withdrawals from the account, but ideally at a point when you’re in a lower tax bracket.
Secondly, municipal bonds are generally not taxed federally or at the state or local level. That makes them strong candidates for brokerage accounts where there is no tax protection. That’s because the nature of a muni bond means you will not need tax shelter, whereas something like stocks needs quite a bit of coverage to avoid hefty taxation.
Thirdly, you might keep fixed-income bonds in a Roth IRA or a Roth 401 (k) to avoid owing ordinary income taxes every year on your interest payments.
There’s a lot of mixing-and-matching you can do with asset location to put this proverbial jigsaw puzzle together. Sharing your financial goals with an advisor can help you craft a winning strategy for whatever stage of life you’re in.
Retirement Planning Tips
If you have questions specific to your retirement situation, a financial advisor can help. Finding a qualified financial advisor does not have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
One item you do not want to forget in your retirement plan is Social Security. These payments help many retirees close the gap between their own savings and the type of retirement they want to live. Use SmartAsset’s Social Security calculator to get an idea of what your benefits might look like.
Tanza Loudenback, CFP® is SmartAsset’s financial planning columnist, and answers reader questions on personal finance topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Tanza is not a participant in the SmartAdvisor Match platform.
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