Is Your Retirement Investment Portfolio Tax Efficient?

Most long term investment and savings goals boil down to achieving a comfortable retirement or reaching financial freedom. Many of us have shorter term financial objectives such as buying a new car or house, maybe saving up for a vacation or investing for our children’s 529 college savings plans. But why not admit it — our minds often toy around with what may seem like more distant goals. Don’t we all want to have financial freedom from the daily toils of the 9 to 5 lifestyle? How does enjoying a lifestyle and doing work independently of having a job sound?

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Is Your Retirement Investment Portfolio Tax Efficient?

It’s not just “here’s the watch; have a nice life” anymore. The fact is that these days, we expect to have longer lifespans, and therefore, possibly more time spent in the retirement phase. It is not uncommon for some people to spend 30 years in retirement. For these reasons, it not only makes sense to have a very good savings and investment plan in place, but also to do it in the most tax efficient way possible. Why? Because taxes, like costs, can take a big bite out of our returns and ultimately our nest eggs. Take a peek at your online broker account and realize that not all of what you see there is yours to keep — a portion of that is going to the tax man!

So who likes to pay more taxes than they have to? To that end, it behooves younger savers and retirees alike to think about how they should manage their retirement funds in a tax efficient manner.

What we are talking about is not tax evasion, mind you. Instead, we’re talking about handling our investments in such a way as to minimize our tax obligations so that we can keep more of our money to better support our retirement.

So how can we accomplish this?

There are three critical factors to retirement fund success: asset location, tax diversification, and spending philosophy.

Let’s go through each of these factors in more detail:

Asset Location

When we talk about asset location (no, that’s not a typo…), we are referring to the ability to maximize our overall portfolio’s expected, after-tax return by positioning assets between taxable and tax-advantaged accounts. This is sometimes also referred to as “preferred domain”. This approach can be most beneficial for people who have a mix of taxable and tax-advantaged accounts and who have a long enough time horizon. To accomplish the optimal mix, you need to place your least tax efficient investments (bonds, high turnover stock funds, etc.) into tax-deferred accounts, and your tax efficient investments (municipal bonds, index funds, etc.) into taxable accounts.

Tax Diversification

It’s not uncommon for people to be in a higher tax bracket during retirement as compared to when they are working. Tax rates are dynamic and future rates are fundamentally unpredictable. You are doing yourself, and your portfolio, a disservice by assuming you will be in a lower tax bracket when you stop working. So, just as it is prudent to diversify between stocks and bonds, you shouldn’t really put your entire nest egg into one tax bracket. That is — don’t bet 100% on one tax bracket since you can’t really predict what the future will bring, in terms of your tax situation. To accomplish this, it makes good sense to hold after-tax, investment accounts and Roth IRAs to complement the pre-tax accounts you may have (i.e. Traditional IRA’s, SEPs, 401(k)s, 403(b)s, etc.).

Spending Philosophy

Most retirees favor “income” and are typically looking for assets that have the best yield. But this approach generally produces ordinary income (taxable bonds, high-yield bonds, cash/cash equivalents such as online savings accounts, bank cds or high yield checking accounts) and tends to focus on dividends rather than long-term gains (which can have favorable tax treatment). Also, many try to minimize taxes by investing in municipal bonds, even when their tax bracket does not warrant them, which produces a lower yield than taxable bonds.

So, what’s an alternative? You may want to consider a “total return” spending approach. Instead of focusing on yield alone, you would spend from income and principal. In this way, you would be reducing ordinary income (and, therefore, taxes) and favoring long-term gains in your overall portfolio; it would steer your portfolio allocation away from an “income tilt” thus allowing a better alignment with risk tolerance and other investment considerations.

Thus when we spend, we would not be drawing yield necessarily, but the amount we need from the appropriate accounts. In doing so, our spending order would be as follows:

• First, taxable assets;
• Second, non-qualified annuities;
• Third, qualified retirement plans and Traditional IRAs;
• and finally, Roth IRA’s, Roth 401(k)s/403(b)s.

Accomplishing a tax-efficient portfolio and ultimately, a retirement nest egg, may take a little forethought. It may also require looking at things a bit differently from a spending perspective. But all this is worth it if you are paying less taxes over the duration of your retirement, which can make a big difference in maintaining your lifestyle and possibly passing assets onto your heirs.

 
Contributing Writer: Todd Smith, CFP

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Categorized under: Investment, Taxes