Society of Certified Senior Advisors: Asset Location: Which Assets Should Seniors Hold in What Accounts?

Want to pay less in taxes next year? Follow our advice on asset location, both before and in retirement, to avoid giving more money than necessary to Uncle Sam.

"You can't control market returns, and you can't control tax law, but you can control how you use accounts that offer tax advantages — and good decisions about their use can add significantly to your bottom line," says Matthew Kenigsberg, Vice President of Investment and Tax Solutions at Fidelity Investments.

Your biggest expense in retirement may not be home maintenance, travel, or even health care. Taxes may be your largest bill, according to government non-profit FINRA, which oversees US broker-dealers. https://www.finra.org/investors/learn-to-invest/types-investments/retirement/managing-retirement-income/taxation-retirement-income Part of savvy financial planning is to minimize taxes by allocating different types of investment assets to different accounts.

Two Kinds of Investment Taxes

You may already be aware that there are two main types of taxes on investments:

Ordinary tax is what you pay every year based on your income, and it can vary from year to year. You pay ordinary tax on interest and dividend income. Ordinary tax can vary from zero to 37%. (Check your rate here).

Who Benefits Most From Asset Location Strategies?

Four criteria determine how much you can benefit from asset location adjustments. Even if only one applies to you, it’s worth checking into. The more criteria that apply to you, the greater the potential benefit.

Your ordinary income tax rate is currently high.
You think you’ll pay a lower marginal tax rate in the future.
You have a lot of tax-inefficient investments in taxable accounts.
You are investing for a long time horizon.

Capital gains tax works a little differently. When you sell an asset, such as a stock, the difference between the price you bought it for (the basis) and the price you sell it for is the capital gain (or loss). Currently, capital gains tax can be as low as nothing up to a high of 20% for assets that you have owned for at least a year and a day (known as long-term capital gains). The percentage you pay depends on your income. Assets that you have owned for a year or less before selling are taxed at your ordinary rate.

Three Types of Investment Accounts

Most investments fall into one of three main types of accounts:

Taxable accounts include basics like your checking and savings accounts and money in a traditional brokerage account (not connected to a retirement account of any kind). You are taxed at your ordinary rate on dividends and interest, or at the capital gains rate for investments, such as stocks, that increase in value.
Tax-deferred accounts include retirement accounts such as traditional 401(k)s, 403(b)s, IRAs, and annuities. You don’t pay any taxes on these accounts, often for decades, until you withdraw from them, at which time the money you pull out is taxed as ordinary income. These accounts are subject to required minimum distributions determined by a government formula that start when the holder reaches age 72.
Tax-exempt accounts like Roth IRAs, Roth 403(b)s and Roth 401(k)s hold assets, often for decades, that will not be taxed at all upon withdrawal, nor will it increase in value. Interest and dividends will not be taxed. Additionally, a Roth is not subject to required minimum distributions. You may be wondering why you shouldn’t just switch all your money to a tax-exempt account. Apart from having to pay ordinary tax on money you invest in a Roth, there are income and contribution limits. Health savings accounts (HSA)s are fully tax exempt in that you don’t pay tax on the contribution, and you don’t pay tax on qualified withdrawals. An HSA is only available if you have a high-deductible health plan.

What Accounts to Use for Different Assets

Because different assets are taxed differently, they should not be tossed willy-nilly into any old account. Here is a list of asset types and what they entail:

Taxable accounts are great for stocks and stock funds that you buy and hold. You will get taxed on the dividends every year, but capital gains won’t be due until you sell them. Stock index funds and index ETFs are also good choices since they trade infrequently. Municipal bonds, also known as “munis,” are perfect for taxable accounts since they generate tax-free income.

Tax-deferred accounts (such as traditional IRAs and 401(k)s) are ideal for bonds and taxable bond funds, which otherwise generate interest that gets taxed annually as ordinary income. Make sure you put any inflation-adjusted bond funds, also known as TIPS, here. The value of these funds goes up with inflation, which the IRS will treat as interest income if they are not sheltered. Another use of tax-deferred accounts is for actively traded stocks. Gains from these are treated as ordinary income and taxed annually unless they are sheltered.

Tax-exempt accounts should hold assets that are taxed at the highest rate, which is often your ordinary income tax rate. Assets that are good for your tax-deferred accounts will also be great here with the added benefit that you can withdraw from them without paying a dime of tax. Actively traded/managed stock mutual funds are widely held and can generate significant capital gains. Keep them here for tax-free growth. Note that some HSAs can be invested in stocks; if your HSA doesn’t offer this option, you may want to look for one that does.

What about cryptocurrency? The government began taxing it for the 2021 tax year, so the decision to invest is an important consideration. If you just buy crypto (including Bitcoin and Ethereum, for example) with dollars and hold it, it’s not taxed. But when you use it to buy something or trade it, watch out.

“Whenever you sell the investment, or exchange the investment for another investment, that is when a taxable transaction happens,” according to Daniel Johnson, founder of RE|Focus Financial Planning in Asheville, North Carolina. “You’ve got to be careful if you’re doing a lot of trading. If you’re going in and out of different types of cryptocurrency, every single time you place that trade, it is a taxable event.”

Asset location is an important part of tax-reduction strategy before and during retirement. Comb through your existing accounts to see if there are any allocations that should be switched over, and make sure to follow the guide when you make changes in the future. Knowing how to utilize the tax advantages you have at your disposal can help ensure your money lasts longer than you do.