Do you have clients who are investing for long-term goals? You can help these clients potentially reduce their tax bills by locating assets in both taxable and tax-deferred accounts. This is commonly called “asset location.”
It’s not always what your clients are invested in that helps create a tax efficient portfolio; often, it’s where those assets are located.
There are two basic steps to helping clients manage taxes through asset location:
Help the client categorize their current assets according to how the assets are taxed.
Review the client's opportunities to relocate assets to help minimize their tax obligation .
One good way to begin the categorization process is to take an inventory using a form such as the one below. Once the inventory is complete, separate the client’s assets according to the following asset and account types.
Some income taxes may be payable each year. Examples:
Income taxes are payable only when assets are distributed or, if applicable, sold. Examples:
Certain distributions are free of federal and/or state income taxes. Examples:
While clients work, investments are typically used for short- and intermediate-term or long-term expenses.
Often, assets that are earmarked for long-term expenses are more tax-efficient if they are located in tax-deferred or tax-exempt/tax-free accounts. Here’s why:
Often used for short- and intermediate-term needs because they are relatively liquid. Even though income tax may arise annually on taxable earnings with this account, clients can access assets at any time without additional taxes or penalties.
Examples:
Typically used for enhancing long-term growth potential. There may be adverse tax consequences for early withdrawals. However, in return, there are no taxes on any earnings until clients need to make withdrawals or take distributions. As a result, clients keep more of the earnings, giving their assets the opportunity to grow faster.
Example:
Can be used to help meet long-term expenses by generating tax-free income in retirement. Although clients pay taxes up front at today’s known rates, they may not need to pay any income tax on account earnings when withdrawn.
Example:
Generally, for earnings from a Roth IRA account to be distributed tax-free, the Roth IRA holder must have held the account for five years AND either attained age 59½, become disabled, passed away, or qualified for a first-time home-purchase exception.
Now it’s time to consider the client’s asset-location opportunities. Examine the client’s current assets and determine which of these categories the assets might fall in:
Tax-Efficient Investments
Consider Locating in Taxable Accounts
Tax-efficient investments produce a lower amount of taxable income or gains during the short or intermediate term, making them possible options to hold in taxable accounts.
Tax-Inefficient Investments
Consider Locating in Tax-Deferred or Tax-Free Accounts
Tax-inefficient investments produce a higher amount of taxable income and/or gains. Tax-deferred and tax-free accounts can take advantage of either a deferral or possible exclusion of taxes on these types of investments.
When clients transition from their working to later years, their financial focus often shifts from growing assets to ensuring they are managing their investments in a way that maximizes retirement income. To achieve that goal, the purpose of thinking in terms of “asset location” should shift from “where should I locate assets?” to “from which locations (accounts) should I withdraw assets?” Consider reviewing the following scenarios with your clients:
1. Before Making Withdrawals, Clients Should Think about Their Net Income
While developing a strategy that will provide income during retirement, you and your spouse realize that after Social Security retirement benefits and pension payments, you’ll need to withdraw a net $13,500 from savings to meet living expenses. Which account should you withdraw from? If the goal is to minimize income taxes and help make your retirement savings last, it may be a good idea to withdraw from the tax-free account. Why?
In this hypothetical example, if you withdraw from the tax-deferred account, it will deplete your savings by an additional $1,840 (12% tax rate). Withdrawing $15,340 would allow you to receive a net $13,500. In contrast, the tax-free account would only require $13,500 to be withdrawn without any additional federal income tax.
| Tax-Deferred | Tax-Exempt |
|---|---|
Withdrawals will be taxed at ordinary income-tax rates. Tax = $1,840 |
No income tax will be due on withdrawals. |
Total withdrawal needed to receive a net amount of $13,500: $13,500 + $1,840 = $15,340 |
Total withdrawal needed to receive a net amount of $13,500: $13,500 |
2. Be Aware of Your Clients' Tax Bracket
Now, let’s add another hypothetical consideration to the previous example. You and your spouse’s annual taxable income from sources other than savings—specifically, long-term capital gains from the installment sale of a business, your pension, and the taxable portion of Social Security retirement benefits—is $68,500.
Source: News releases. "IRS provides tax inflation adjustments for tax year 2024." IR-2023-208, Nov. 2023. IRS.gov
The takeaway from this example: Let clients know that moving to a higher income-tax bracket not only impacts taxation on ordinary income, but may also result in paying:
The above is provided for informational purposes only and should not be construed as investment, tax, or legal advice. Information is based on current laws, which are subject to change at any time. Clients should consult with their accounting or tax professionals for guidance regarding their specific financial situations.
Annuity withdrawals and other distributions of taxable amounts, including death benefit payouts, will be subject to ordinary income tax. For nonqualified contracts, an additional 3.8% federal tax may apply on net investment income. If withdrawals and other distributions are taken prior to age 59½, an additional 10% federal income tax may apply. A withdrawal charge and a market value adjustment (MVA) also may apply. Withdrawals will reduce the contract value and the value of the death benefit, and also may reduce the value of any optional benefits.
Under current law, a nonqualified annuity that is owned by an individual is generally entitled to tax deferral. IRAs and qualified plans—such as 401(k)s and 403(b)s—are already tax deferred. Therefore, a deferred annuity should be used only to fund an IRA or qualified plan to benefit from the annuity’s features other than tax deferral. These features include lifetime income, death benefit options, and the ability to transfer among investment options without sales or withdrawal charges.
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