When it comes to retirement planning, everyone wants to save on taxes. While many discussions revolve around various strategies, they often remain conceptual. Today, we’re diving into a real-world example that illustrates how effective asset location can lead to significant tax savings and increased retirement wealth.
Before we delve into the specifics, it’s essential to clarify the difference between asset location and asset allocation. Asset allocation refers to how you distribute your investments among different asset classes, such as stocks and bonds. In contrast, asset location focuses on where you hold these investments—specifically, in taxable, tax-deferred, or tax-free accounts.
Let’s consider a hypothetical client portfolio consisting of 72% equities and 28% fixed income. This allocation is slightly off from the targeted 70-30 split, indicating a need for adjustment.
Upon reviewing the asset location, we discovered that the client held the same allocation of stocks and bonds in both their taxable and tax-deferred accounts. This is where the opportunity for tax savings arises.
By relocating some fixed income assets from the taxable account to the tax-deferred account, we can optimize the tax efficiency of the portfolio. This strategy is crucial because it allows us to "hide" income-generating assets in accounts where they won’t impact the client’s tax bill immediately.
After implementing this strategy, the client could potentially see:
The reason for these substantial savings lies in the reduced future required minimum distributions (RMDs) from the tax-deferred accounts. By lowering the amount that must be withdrawn, the client pays less in taxes and retains more wealth for their retirement.
In the year of the asset relocation, the client’s tax return would reflect significant changes. By moving fixed income to the tax-deferred account, we can reduce ordinary and qualified dividends, leading to immediate tax savings. This is because any income generated in a taxable account is reported directly on the tax return, while income in a tax-deferred account is not taxed until withdrawal.
To achieve the desired allocation, we would sell off some fixed income assets in the taxable account and reinvest in equities. In the tax-deferred account, we would adjust the holdings to maintain the overall target allocation without adding new money.
Implementing an effective asset location strategy can lead to immediate tax savings and long-term financial benefits. By strategically placing investments in the right accounts, you can significantly enhance your retirement wealth and reduce your tax burden.
If you’re looking to optimize your portfolio and implement similar strategies, don’t hesitate to reach out for personalized advice. Maximizing your tax efficiency in retirement is not just a goal; it’s a necessity for a secure financial future.