I was listening to a podcast the other day and a retiree was providing wisdom to future retirees. One of the best ways to learn is from the lessons of current or recent retirees. They can provide some real-life examples of stuff we are about to experience. It becomes more practical and less theoretical when you hear it from a recent retiree. Anyway, not only did I hear the podcast but the next day, I read a popular blogger (and fairly recent retiree) say the same thing.
That thing they regret is their asset location. I’m not talking about asset allocation, which is the collective investment percentage you have of all types of investments. Asset allocation attempts to balance risk and reward by the types of investments (stock, bonds, cash, real estate and other assets) in your investment portfolio. This is where’d you normally hear about asset allocations like 50% stock, 30% bond, 15% alternatives, and 5% cash. Again, I’m not talking about asset allocation.
I’m talking about where you’re putting those assets or investments once you own them. Remember, stocks can be in tax deferred, taxable, and tax free accounts and it’s the percentage allocation to those accounts they’d do differently. The ramifications of where your investments are located can significantly impact your retirement and it takes strategic thought to intentionally create your desired state.
Where you keep your money located is more than just about maximizing your after-tax returns (though this is critical). You need to consider how your income could impact the cost of Medicare premiums. And if you want to leave somebody an inheritance that is a factor too for asset location. Vanguard considers asset location to be worth up to .75% (or 75 basis points) in value to an investor. If done right, draw-down flexibility is an important benefit of asset location. Having the choice of pulling funds at any given time from either tax-free, tax deferred, or taxable accounts can’t be underestimated.
My Asset Location Journey
Retirement planning is complex. There’s a never ending stream of old and new data/information that either makes you slightly tweak or completely change a plan. It’s no wonder that people don’t know where to start or are intimidated by the entire process. Unfortunately, this causes many to not even save. In reading some of the regrets or lessons learned from current retirees, many of these are very smart people and this one area just fell through the cracks. But they regret it in retirement.
Well, it’s on my radar now and I’m actively doing something to change my plan. As early as 12/31/20, I had investments in tax deferred (i.e. pre-tax 401k) and taxable accounts. Really, I had nothing invested in tax-free accounts. Several years ago, I opened a small Roth IRA that only has about $200 in it today. But my good news is my employer FINALLY allowed us to participate in a Roth 401k. This was a complete game changer for my asset location strategy (meaning I now needed a strategy). Not only that, but they also allowed something many companies don’t allow – Roth In-Plan Conversions (which I wrote about a few weeks ago). My Roth In-Plan Conversions were another game changer.
Pre-Conversion
Due to spending and (eventually) income obstacles (i.e. making too much), I was unable to really get into the Roth IRA mindset. Years ago, I opened a small Roth IRA and tried to grow it through trading and crappy stocks. Prior to 2021, I only had tax deferred and taxable accounts. Combined with a pension and social security, I was setting myself up for significant Roth IRA conversations and/or RMD’s (required minimum distributions) in retirement.
At work, I’ve been contributing to a regular 401k and the non-qualified 401k. Again, both of these were tax deferred. Finally, my company joined the “cool company” crowd and provided us with a Roth 401k option. So, in 2021 I did what I could to maximize that contribution. Within 9 months, I finally had about $20,000 in a tax-free Roth 401k. Of course, only 3% of my investment portfolio was now in a tax-free account but it was a start.
Unfortunately, I’ve only got 3 1/2 years left until I retire so I was looking for options. That’s when I found the Roth In-Plan Conversion option that my company allowed, which is allowing me to get my funds into a tax free status much quicker. That’s why I call this part of my journey the “pre-conversion” section.
Current
What a difference a couple of months make. After converting $40,000 last month into my Roth 401k (via a Roth In-Plan Conversion), I suddenly went from $20,000 to $60,000 into tax-free accounts (8% in tax-free). And it’s very possible that I’ll convert another $15,000 by year-end. If I do this, I’d got from $0 last year to $75,000 into tax-free. This would move me to about 10% into tax-free accounts.
Sure, I’ll be paying nearly $15,000 in taxes for my conversion next tax day but the long-term positive impact will be significant. Everyone’s situation is different so make sure you consult with a tax professional before converting. You don’t want to create a mess because you can’t convert back.
Desired
Today, I’ve got about $340,000 in a regular tax deferred 401k. I’m hoping to convert much of these funds before I get into retirement. That will still leave over $200,000 in tax deferred non-qualified plan but that will payout the first 5 years of retirement. So, by 67 years old I should be nearly 50/50 with taxable and tax-free accounts. This means no required minimum distributions, tax free growth, and lots of drawdown flexibility.
I’ve got some work to do though. Converting that $340,000 into a Roth will mean additional taxes of nearly $95,000 to pay. That $95,000 would have gone into a taxable account but paying taxes on the conversion with already taxed funds is optimal.
The White Coat Investor wrote a nice article on asset location a couple of years ago. In that article, they identified 6 principles of asset location that are worth repeating here:
- The higher the expected return, the more likely the asset should be in a tax-protected account
- The lower the tax-efficiency, the more likely the asset should be in a tax-protected account
- The more likely you are to avoid paying capital gains taxes, the more likely you should put capital gain assets in taxable
- The more volatile the Investment, the more likely it is better in taxable
- Place high expected return assets into tax-free accounts but recognize you are taking on more risk
- If you have an RMD problem, increase your tax-free to tax-deferred ratio
My desired asset location is fluid but it’s a plan. I’ll update that plan each year but the point is to think about what you want before you retire. The more time you have to adjust the easier (and less painful) the execution. I’d sure love to spread out my Roth conversion tax liability over decades versus only a few years but that’s not possible anymore.
Summary
If I can execute my plan of converting money into my Roth 401k before retirement, asset location will not be on my list of retiree regrets. There are so many components in retirement preparation that asset location isn’t the highest issue on the list. But like I told my wife this morning, if you are going to invest then you might as well locate that asset in the type of account that is desirable in retirement.
This form of retirement planning can slip between the cracks because most people just don’t save enough. If that’s the case, then asset location is not a huge priority. But if you are a good saver, make a good income, and expect to have multiple streams of income in retirement, then asset location can be significant. Consider your current and future state – where are your assets today and where (and why) do you want them at retirement – and create a plan to get to your desired state. The sooner you recognize this the easier and less painful it will be to action.
I believe in everyone paying their fair share of taxes but that doesn’t mean I need to be stupid about it. If tax laws pave a path to enable me to pay less in tax as a retiree (versus now) then I’ll take advantage of that. I don’t want to be forced into taking required minimum distributions (RMD) from my tax deferred accounts when I’m 72. With my pension, social security, and dividends, taking an RMD would likely have a negative impact to my net worth and increase my taxes. It could also reduce the inheritance my kids receive some day.
Thanks for reading!
Mr. TLR