In the world of investing, there are two crucial decisions that individuals need to make: allocation and location. Allocation involves determining what percentage of your net worth you want to invest in various assets, such as stocks, bonds, and cash. Location, on the other hand, refers to where you place these investments – whether in taxable or tax-sheltered accounts. Most savers approaching retirement have assets divided between retirement accounts and taxable accounts, making the decision of where to place each asset essential.
Financial planner Allan Roth, based in Colorado Springs, works with clients who may have municipal bonds in a taxable account and stocks in a tax-sheltered account, which he deems as an inefficient allocation. Roth suggests reallocating assets, such as selling municipals and investing in stock index funds, and shifting stocks to high-grade bonds within the retirement account. By following this strategy, clients can achieve a higher, tax-sheltered return on fixed income investments, with lower tax implications on stocks.
The hierarchy of investments based on their need for tax sheltering is crucial in maximizing investment returns. Bonds, which generate high-taxed ordinary income, should be prioritized for sheltering in retirement accounts. In contrast, stocks, which are taxed at lower rates, should be last in line for placement in retirement accounts. Muni bonds, often perceived as tax-exempt, are not truly tax-free as their taxes are already factored into lower yields. By strategically reallocating investments, individuals can potentially save significant amounts in taxes over the long term.
One effective tax-sheltering strategy is to prioritize the highest return assets in Roth accounts, especially for investors who expect their tax brackets to remain stable. With Roth accounts offering tax-free withdrawals, these accounts can be beneficial for assets with the greatest growth potential. However, the choice between pretax IRAs and Roth IRAs is less compelling for individuals with consistent tax brackets. Understanding the tax benefits of each account type can help individuals make informed decisions about where to place their investments for maximum tax efficiency.
The ranking of assets based on their benefit from tax sheltering provides a clear guide for investors looking to optimize their investment returns. Certain assets, such as high-yield corporate bonds and income stocks, are best placed in retirement accounts to minimize tax liabilities. On the other hand, assets like U.S. Treasuries and growth REITs may fare better in taxable accounts due to their tax treatment. By carefully evaluating the tax implications of each asset, investors can create a tax-efficient investment strategy that aligns with their financial goals.
In summary, understanding the benefits of tax-sheltered accounts and strategically reallocating assets can result in significant tax savings for investors. By prioritizing high-taxed assets for sheltering and considering the tax implications of each investment, individuals can optimize their investment returns over the long term. With proper planning and a clear understanding of tax-efficient investment strategies, investors can maximize their after-tax income and build a strong financial foundation for the future.
