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Here are examples demonstrating how asset location, the taxable status of assets, can impact the amount of income for retirees:

The following hypothetical examples assumes a retiree with $1.5 million in retirement assets at age 65 continues to grow assets at a 5% rate of return. All examples assume the retiree takes annual income for 25 years, such that the account is zero at the end. The tax assumptions are:

• For the tax-deferred account, all income is 100% taxable at a 30% assumed tax rate.
• The taxable example uses a brokerage account with 50% of the income being taxed at the capital gains rate of 15% (assumes cost basis is 50%, which is non-taxable).
• The tax-free account uses a Roth IRA in which all qualified withdrawals received are tax-free.

Based on these assumptions, a retiree may have a difference of $30,000 in after-tax annual income in retirement between tax-deferred and tax-free accounts. The difference would be greater using higher tax rates and less with lower tax rates. While the best retirement plans informed by asset location hold a mix of all three categories, needs will vary by individual.

How much difference can asset location make?

To illustrate the very real impact of asset location on what retirees get to keep and spend of their retirement savings, consider this example of how the tax position of the savings sources being tapped for retirement income can vary retirement income and lifestyle:

What you earn isn’t always what you keep

Hypothetical example:

Joe, a 37-year-old engineer, contributes $22,500 per year pretax to his 401(k) and gets a $7,500 company match each year until he retires at age 65. Both pre and post-retirement, his portfolio grows at 6%. If we assume Joe’s tax liability at any point in time is 30% (both on portfolio value and distributions), his gross annual income will be $245,063 until his 401(k) is depleted at age 90. However, after taxes, Joe will only get to keep $171,544 of that in his pocket, and $73,519 will go to taxes.

Building an asset location strategy that safeguards retirement portfolios against tax exposure requires an understanding of the account types within which to accumulate savings and their tax treatment upon distribution.

Tax-deferred income

401(k)s, 403(b)s, 457s, and other qualified plans, traditional IRAs, Social Security, annuities Pretax dollars — fully taxable as ordinary income at distribution

Taxable income

Brokerage accounts, savings, money market, all 1099 income Savings are taxed as they are accumulated in after-tax dollars

Tax-free distributions

Roth IRAs and Roth 401(k)s, municipal bonds, cash value life insurance, variable universal life distributions are tax-free in retirement

Each account type, tax-deferred, taxable and tax-free, has its strengths and drawbacks. Asset location is designed to enhance the benefits of each account and reduce the costs by positioning assets in each group. By targeting certain assets within each account and balancing funding, you may significantly reduce your tax burden and increase portfolio returns.

Conclusion

Many financial professionals agree that the largest drags on portfolio performance in the long term are behavioral risks, fees associated with investing and taxes. Asset location seeks to reduce one of those biggest drags — taxes — without diminishing a preferred investment strategy, risk profile or certain objectives. By simply reviewing assets and their proper account location, you may significantly reduce tax burdens, which can result in increased portfolio returns.

Investing involves risk, including possible loss of principal.  Asset allocation and diversification do not ensure a profit or protect against a loss.