Investing in the stock market isn’t easy. In fact it’s downright hard! The fact is 99% of investors focus on their investment portfolio for returns. The truth is they should be focused on other critical aspects of investing as well.
Your performance shouldn’t be measured by investment returns alone. In reality your real returns are the total capital gains and dividends you receive MINUS the taxes and costs paid to achieve those returns. It’s the NET dollars in your pocket that matter right?
Because it’s the net dollars that really matter to you, you must broaden your focus. Don’t just watch your investment growth, watch the fees and taxes you pay to get them.
One way you can boost your returns is by slashing your taxes. A great way to slash your taxes is by properly allocating your assets among various types of investment accounts. IRA’s, Roth IRA’s, taxable accounts and tax deferred accounts like annuities can reduce your taxes if used properly.
A tax efficient asset location plan is a critical component of your retirement. By properly placing various types of assets between IRA’s and Roth IRA’s you can increase dollars in your pocket by the amount of taxes you’ll save!
So just how do you create a tax efficient asset location between your IRA and Roth IRA accounts?
Required minimum distributions
The first thing to remember is the IRS wants their pound of flesh (in the form of taxes) at some point. They don’t want your IRA or 401k to keep growing tax free forever after all! Because of this you’re required to start pulling money out of your IRA’s when you reach age 70 and 1/2. This is called your “required minimum distributions”.
It starts off being a small amount each year and grows as you age. The amount is based on your prior year end IRA balance divided by a number on a life expectancy table. With each successive year those required distributions increase substantially.
The more you’re required to withdraw, the higher your tax bill will be. The older you get, the more you’re required to withdraw.
Some people make the mistake of thinking you need to spend your required distributions. This isn’t the case. The IRS doesn’t care what you do with the amounts withdrawn, only that you pull them out of the IRA triggering tax revenue for Uncle Sam.
Understanding that as you age you’re required to withdraw funds from your IRA is the key to tax efficient asset location. You’ll pay ordinary income taxes on your required minimum distributions after all. Since you’re forced to pay taxes it’s best to set up your investments to reduce those taxes as much as possible!
Our basic assumptions for tax efficient asset location
We’ll make the following basic assumptions for our infographic:
- A $200,000 total portfolio
- $100,000 in an IRA
- $100,000 in a Roth IRA
- 50% stock and 50% bond allocation
- Annual portfolio rebalancing
- Tax rate is 15%
- Stocks earn 8%
- Bonds earn 3%
- 30 year timespan
- Starting at age 60
These are very basic assumptions for the purposes of our tax efficient asset location example. You could argue the assumed rated of return on stocks and bonds. You could argue the tax rate. In the end these are very realistic assumptions.
Note: If the difference in growth rates was less the result wouldn’t be as prominent. Regardless, the result would still be positive in favor of the tax efficient asset location strategy between your IRA and Roth IRA.
The IRA/Roth IRA asset location strategy
Since Roth IRA’s currently have no required minimum distributions they can grow tax free until you die. When you die your heirs can take inherited Roth IRA distributions over their lifetime (under current law).
Tax rates are also at historic lows. With the current state of our national debt it’s likely tax rates will rise. If tax rates do rise a tax free stream of income is a very powerful thing to leave to your heirs!
Clearly a Roth IRA is a powerful tool. IRA distributions are taxable so the more your IRA grows the more in tax you’ll pay upon distribution. Because of this you want as much in the Roth and as little in the IRA as possible.
By putting your higher growth assets in the Roth IRA and your lower return investments in the IRA your required distributions will be smaller. Your Roth IRA will also grow more over time.
That’s the strategy, and we built an elaborate spreadsheet to prove it! Check out the infographic above for the breakdown on how and why this works.
But the financial plan trumps all
It doesn’t matter how powerful this strategy is if your financial plan isn’t working. You must have a financial and retirement plan which charts your lifetime streams of income and how you’re going to accomplish those streams of income. That same financial plan should also dictate your asset allocation plan (meaning how much to put in stocks versus bonds and the micro management between all asset classes).
Why do I mention your plan trumps all? Because rebalancing is a critical part of keeping your financial plan on track. By keeping your asset allocation in check, you keep your risk/reward profile in check and avoid big surprises. For this reason, we rebalanced both accounts in this infographic.
Tax efficient IRA and Roth IRA management summarized
Every dime matters! Stop focusing on one aspect of your returns. There are other things which are equally as important such as keeping fees and expenses low and slashing taxes.
In this hypothetical – but realistic – example, Jane made an extra 45K during retirement. While she didn’t technically “earn” that 45K the effect of it is the same. She saved that 45K in taxes over time. This gave her more retirement income to spend and/or a larger tax free inheritance for her family.
Rebalancing your investments between accounts can get challenging. Tax efficient location strategies can make it even more complex. Since your financial plan dictates your investment plan it’s important to keep both on track. Whatever your asset allocation is, you should pay care and attention to maintaining it properly.
There’s no doubt there’s a large amount of tax savings to be had by using this strategy. It’s fairly simple on the surface, and very powerful in substance.
Put tax savings on the forefront of your investment strategy and locate your assets properly between Roth IRA and IRA. Doing this will truly maximize your returns.
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Can you talk about how to maintain asset allocation when converting from a traditional IRA to a Roth IRA in retirement. Let’s say all of your bonds are in the traditional IRA and your growth funds are in the Roth. Is it as simple as opening a bond fund in the Roth or is there some other way?
Hey Brian thanks for the question! I literally just posted a new blog on asset LOcation here. That being said, it’s as easy as converting SHARES of your investments instead of dollars. There’s no reason for you to sell investments in the IRA and rebuy them in the Roth when you can just transfer shares. This should also save you the trade costs (if any). Your allocation will remain the same, just make sure you periodically check the whole plan for tolerance. I wrote another blog on portfolio rebalancing recently also. Best wishes!