From the November 2008 issue of Boomer Market Advisor • Subscribe!

November 1, 2008

Consider the 'where' in asset location

Boomers are wondering which investment strategy, if any, is right for their retirement dollars. As they watch their hard-earned savings move with each day's news, it is obvious that there is no simple answer to the investment selection question. There is, however, a different question that should be asked -- one that is often overlooked as retirees move from the accumulation to the distribution phase of their retirements. How should they allocate their investments within taxable and tax-deferred accounts?

The general rule of thumb for investors in their pre-retirement accumulation years is to invest for growth in IRA (or other tax-deferred) accounts and to invest more conservatively in taxable accounts. This works relatively well in the time leading to retirement -- taxes on the IRA growth are deferred, and income and capital gains taxes from the less aggressive taxable account are kept to a minimum.

Once retirement income becomes necessary, however, we generally advise that clients consider reversing this allocation -- moving the more aggressive investments into the taxable account, while lessening the risk in the IRA account.

For example, let's say Sally has two accounts on the day she retires; one is an IRA account with a moderately aggressive stock portfolio and the other is a taxable investment account invested in high-quality bonds and CDs. Each account is valued at $200,000.

She then sells off her equity positions in her IRA account and invests the $200,000 into a bond position that pays out 5 percent a year. This has no tax consequence to her at the time of sale.

In her taxable account, she sells off her bond/CD portfolio and invests the $200,000 in a tax-managed, diversified equity fund that grows at 8 percent per year. Let's assume that there are no capital gains taxes owed for the sale. This will provide a cost basis for the new investment of $200,000.

Let's also assume that she takes only the income/growth from the two accounts, and pays the appropriate taxes (15 percent capital gains, 31 percent ordinary income) from the proceeds. The IRA generates $6,900 of net income ($10,000 income minus $3,100 taxes at 31 percent). The taxable account generates $13,600 of net income ($16,000 income minus $2,400 taxes at 15 percent). This combination generates total net income of $20,500 per year.

Say Sally started with this portfolio at age 60 and just stripped the income/gains from the accounts each year -- and for the sake of illustration there was no change to the investment return or tax rates. She could live to age 90 having taken $615,000 of income from the portfolio, and still leave her original $400,000 initial investment to her beneficiaries.

Let's examine a second investor, Bob, who maintains the status quo and leaves his growth stocks in his IRA and his more conservative holdings in his taxable account. The IRA account generates $4,960 of net income ($16,000 income minus $4,960 taxes at 31 percent). The taxable account generates $6,900 of net income ($10,000 income minus $3,100 taxes).

The tax-drag on this scenario reduces the total net income received over 30 years from $615,000 to $538,200.
Now, if Bob wanted to match the net income provided by Sally, he would have to take some of his principal each year to meet her $20,500 annual net income target. In order to capture the same amount of net income from the equity holdings that Sally is receiving, he would have to withdraw an extra $3,710 per year from his IRA principal. This reduction of principal would eventually deplete the IRA assets by the time Bob turns age 81. In order to keep the income levels up, Bob would then have to take accelerated withdrawals from his taxable account -- and completely wipe it out by age 89.

By making a small strategy decision to alter the location of her assets early in retirement, (while receiving the same investment returns and tax rates as before), Sally enjoys income for life and leaves $400,000 to her beneficiaries at age 90. By maintaining the status quo in his accounts, Bob runs out of money at age 89. A seemingly minor decision (or non-decision) can make a crushing difference during the distribution phase of retirement.

Mark A. Cortazzo, CFP is senior partner with MACRO Consulting Group in Parsippany, N.J.

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