The Hidden Tax Benefits of Investment Location

Are you possibly paying more in taxes than necessary? In this article, we’ll explore a strategy that few people are discussing but has the potential to significantly reduce your IRS bill.

Picture this scenario: Two retired couples with identical investments and incomes, yet one couple manages to save an average of $7,500 in taxes every year. How is this achievable? The answer lies in a simple yet often overlooked tactic involving their retirement savings. Let’s dive into how you can potentially save thousands in taxes, just like one of these couples did.

Before we dive into the details, let’s lay some groundwork. When planning their retirement savings, individuals typically focus on asset allocation. This involves deciding what percentage of their portfolio should be invested in stocks and what percentage in fixed assets like bonds, CDs, treasuries, and other fixed-income investments. Asset allocation is often determined based on one’s risk tolerance. For example, individuals averse to risk may opt for a portfolio with a higher percentage in fixed-income investments and a lower percentage in stocks. While individual preferences can lead to variations, we commonly encounter three allocations: 50/50, 60/40, and 70/30.

The Overlooked Strategy: Investment Location

However, once you’ve settled on your asset allocation, many overlook another crucial consideration: Investment location. Imagine you’ve decided on a 60/40 investment mix for your overall portfolio. If you have a pre-tax IRA, a Roth IRA, and a joint account, should all these accounts mirror that 60/40 mix, or should you strategically allocate different investments to each account? This is where investment location comes into play, and it can significantly impact the amount of taxes you pay.

Let’s examine an example. Consider a couple retiring at age 65 with $1.5 million in pre-tax IRAs, $400,000 in a joint account, one spouse receiving a social security benefit of $3,200, and the other receiving $1,900. They aim to have $9,000 in net spendable dollars each month to cover their living expenses and fulfill their dream lifestyle. After careful consideration, they’ve settled on a 60% allocation to stocks and 40% to fixed-income investments. This means that out of their $1.9 million total portfolio (combining the IRA and joint account), just over $1.1 million should be allocated to stocks, and $760,000 to fixed-income investments.

Now, the question before them is how to distribute these assets. Should they maintain an identical allocation in both accounts, applying the 60/40 split to both the IRA and the joint account? Alternatively, should they allocate all of their joint account funds to fixed income, filling up the IRA with the remaining fixed allocation, and putting the rest of the IRA into stocks? Or perhaps, should they reverse this approach, placing all their joint account funds in stocks and investing all the fixed income in the IRA before filling up the rest with stocks?

While the overall allocation remains consistent across these three options (60% stocks and 40% fixed income), the key difference lies in the taxation of these account types. The joint account generates a 1099 each year, including capital gains, dividends, and substantial interest income. In contrast, the IRA sends out a 1099 only in distribution years, and all withdrawals are typically taxed as ordinary income, without the preferential tax treatment of capital gains or dividends. Consequently, it often makes sense to load taxable accounts (e.g., single, joint, or trust accounts) with investments that produce less income and have lower tax liability.

Let’s use these three scenarios to illustrate the significant impact that proper asset location can have on cumulative taxes in retirement for this couple.

The Impact of Investment Location on Cumulative Taxes

In the baseline scenario, where all accounts are allocated identically (the most common strategy), the cumulative taxes over 10 years amount to just under $63,000. If the allocation were evenly split between accounts, each having the same 60/40 allocation, taxes would be nearly $10,000 higher. In the strategy that reverses it and places fixed income in the taxable account, taxes would be almost $20,000 higher.

By age 80, the difference between getting asset location right and wrong escalates to $40,000. At 85, the gap widens to $90,000; by age 90, it skyrockets to $185,000.

Ultimately, choosing the right accounts to hold the right investments can have a significant impact on your overall tax burden. While there may be exceptions, such as Roth conversions or unique portfolio objectives, it’s essential to recognize that these seemingly small decisions can make a substantial difference. If you haven’t considered investment location before, we highly recommend taking a closer look to potentially unlock hidden tax benefits.