Few topics receive as much attention from retirement income planning experts as where clients should direct their savings.
Whether tax-deferred accounts like 401(k)s and individual retirement accounts, post-tax Roth accounts, or standard savings or brokerage accounts, for many, achieving “tax diversification” is a reasonable strategy, experts say. They cite the unknowns of a client’s income level during retirement and where tax rates could go.
But one question that gets less attention, Ed Slott and Jeff Levine maintain, is whether assets in these accounts should be invested differently according to their current and future tax status.
The retirement income planning experts, both CPAs, address the topic on the latest episode of the Great Retirement Debate podcast, and while there is some debate to be had, they feel the answer is pretty clear for most people.
“Each situation is unique, of course, but I'm going to go with a ‘yes’ on this one,” Levine said. “You should always make sure to do what's best for each individual client’s unique situation. But at the end of the day … it’s not just about the account balance. Locating certain investments within certain types of accounts can have a really significant impact on how much they get to take home.”
Pros and Cons of Taxable Brokerage Accounts
As Levine and Slott discussed, it’s common for people to say that taxable brokerage accounts are the “worst” type to save for retirement.
“They say this because, if you make a dollar in that type of account, you're going to pay tax on that dollar,” Levine said. “If you have a dollar of interest, you're going to pay tax on the dollar of interest. If you have a dollar of dividends, you're going to pay tax on the dollar of dividends.”
That’s true as far as it goes, Slott and Levine agreed, but taxable accounts have some real advantages. For example, long-term capital gains and qualified dividends have different tax rates compared with standard income tax rates.
“There are lower tax rates for that income, but you only get the benefits of those lower tax rates if that income is inside an already-taxed account, like a joint account or a revocable trust account,” Levine said.
This isn’t true for tax-deferred IRAs, they noted.
“If you create a dollar of long-term capital gains in an IRA, it doesn't matter when you take it out of the IRA,” Levine said. “It's going to be taxed as ordinary income, because everything that comes out of an IRA is ordinary income.”
Another feature of taxable brokerage accounts is that, when values fall, clients can use tax-loss harvesting to potentially lower future taxes. As such, Levine and Slott said, it could make sense to hold more volatile investments within a taxable account, especially for more sophisticated investors willing to use strategies like tax-loss harvesting on an ongoing basis.
Traditional and Roth IRAs
As is well understood, traditional IRAs benefit from both contributions and growth being tax-free.
“People like the idea of not having to pay tax on your interest, your dividends, your capital gains,” Slott said. “So, if you are investing in something that throws off a lot of income or you have a lot of turnover in your portfolio, this account style makes a lot of sense. You don't have to worry about that ongoing tax bill.”
The tradeoff, of course, is that funds in the account are eventually subject to ordinary income tax rates — including funds that would have otherwise been taxed at more favorable rates. Traditional IRAs are also less efficient for many estate and legacy planning purposes outside of charitable giving.
Roth accounts, by contrast, are funded with after-tax dollars. While less goes into the account up front, the funds grow tax-free and do not trigger ordinary income taxes on future withdrawals (assuming certain rules and requirements are met).
Affect on Different Investments
Even as these accounts have different tax characteristics, Slott and Levine observed, many investors do not shape their portfolios accordingly. A substantial number of savers deploy a 60-40 stock-bond distribution in all accounts, potentially complemented by real estate and small alternative allocations.
“That’s a common approach,” Levine said. “But another approach is to favor the traditional IRA for assets that are not very tax friendly — fixed income investments, for example, which kick off a lot of income every year [when interest rates are high.]”
On the other hand, clients might consider putting their stocks into a taxable account, Slott and Levine said, because they will be taxed at long-term capital gains rates.
“Anyone inheriting those assets will also get a step up in basis, which can be a big deal,” Levine said.
Likewise, highly tax-efficient assets like municipal bonds are likely best held in a brokerage account.
Further, Slott and Levine noted, an asset with a potentially large upside is probably best held in a Roth IRA. Once the tax on the asset is paid up front, all future growth and income can be accessed tax-free.
“With the Roth, you’ll never be taxed for income or capital gains,” Levine said. “So, when you're thinking about sort of the ideal investments for different accounts, it’s important to consider what has the highest return potential over the long term. … Your ideal investment for a Roth account is something that kicks off a ton of ordinary income. Not only are you getting a high return, but you're taking something that would've otherwise been taxed at a very high tax rate and making it tax-free over the long run.”
When else might a taxable account be favored?
“You generally want to favor things that are super tax efficient,” Levine said. “For example, municipal bonds would be a great example. They’re federally tax free.”
Pictured: Jeff Levine, left, and Ed Slott
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