Tax Planning: Asset Location Basics

Federal and State Income Taxes are often the largest expense for a household. Therefore, we recommend paying regular attention to tactics that will minimize each year’s taxes, as well as strategies to minimize lifetime taxes. The rules about these accounts, and therefore the strategies to use them, are many and varied. In today’s post we will focus on the strategy known as “asset location,” which means, holding each of one’s various asset types in the type of account that is most likely to result, over the long run, in the lowest individual taxes. This whole area of tax planning is complicated, and generally a financial adviser with knowledge of the tax code is needed to help navigate the maze of rules.

First, some terminology about account types. For the purpose of tax planning, we categorize investment accounts according to their tax treatment:

  • Qualified Accounts. These are the ones everyone thinks of as “retirement accounts.” Examples are Individual Retirement Arrangements (IRAs), 401(k) and 403(b) plans, Self Employed Plan IRA (commonly referred to as a SEP or SEP-IRA), and the less-common SIMPLE plans, plus a few others. A good overview of the rules relating to these accounts can be found here.
    • These are bought with pre-tax dollars, and while money is in the account, taxes on gains are deferred.
    • To encourage keeping money in the account, there is generally a penalty for distributions taken before age 59 ½ (in some cases age 55). These accounts also require minimum distributions, generally once the holder reaches age 72.
    • At the time money is withdrawn, the original investment plus any growth is taxed at ordinary income rates. As of this writing, the top tax bracket is 37% (Federal) and 13.3% for California. It is widely anticipated that these top brackets will increase in the near future.
  • Non-Qualified Accounts. For most people, these are individual, joint, and living trust accounts.
    • Funds are invested with after-tax dollars. Interest, dividends, and distributed capital gains are taxed yearly.
    • The tax rate that applies here depends on the type of income: interest income is taxed at the ordinary income rates shown above; dividends and capita gains are generally taxed at the capital gains rate. As of this writing, there is a 0% capital gains bracket (which we will discuss later). Most taxpayers fall in the 15% capital gains bracket, and the highest incomes are taxed at 20%. Plus, above certain income thresholds, the 3.8% Net Investment Income Tax applies.  In California, all investment income (interest or capital gains) is taxed at the applicable state income tax rate, up to 13.3%. Most middle-income Californians are taxed at the 9.3% bracket.
    • Unrealized capital gains are not taxed until the asset is sold. This means that most of the gains in these accounts can be deferred indefinitely.
    • Under present tax law, there is also a step-up in basis at death: when someone inherits an asset, the new basis is the date it was transferred. For now, this is a way to pass on significant wealth to heirs, without ever having to pay tax on it. However, some have proposed to eliminate this provision in the near future.
  • Roth Accounts. These include Roth IRAs, Roth 401(k)s.
    • The “Roth” accounts include the Roth IRA and Roth 401(k) plan. Funds are invested with after-tax dollars but gains and income are never taxed.
    • There are penalties for early distribution of gains, but the original investment amount can be distributed at any time.
    • Assets can be passed to heirs, but the heirs are subject to required minimum distributions.
  • Roth-Like Accounts include Health Savings Accounts and 529 plans (plus a few others).
    • 529 plans. These accounts are funded with post-tax dollars. In some states (not California) there is a state income tax deduction or credit on amounts invested. Amounts grow tax-deferred and can be used for most qualified education expenses free of state or federal income taxes. Federal law allows both K-12 and college tuition as qualified expenses, but in California, only college is free of state income tax.
    • Health Savings Accounts are funded with post-tax dollars in most states other than California. These accounts grow tax-free and can be used for qualified Health expenses without tax or penalty.
    • Alas, California and New Jersey are the only states to completely disregard Health Savings Accounts. California taxpayer should be aware that income on these accounts is an addition to Federal gross income in calculating California income, making it subject to California state income tax.

The first principle of Asset Location is to have a diversification of assets by tax treatment. Fund accounts in as many of the above types as possible. Later in life, when you have reached financial independence, tax diversification gives you choices about how to realize income. Here is an example:

  • First, imagine having all your assets in traditional IRA or 401(k) accounts: any spending is taxable at ordinary income rates. Say you are age 66 and Married Filing Jointly in California. If you want to spend $100,000 for living expenses, you must withdraw about $115,000, to cover the Federal and State income taxes. This case omits many tax details, but we next compare that to the alternatives.
  • In the second case, imagine having all your assets in a Roth IRA or 401(k) plan. Now, all funds can be withdrawn without any taxes at all.

The takeaway: the same amount of money in a Roth IRA lasts longer in retirement, all other things being equal. Of course, in order to have the same amount in a Roth account, the taxpayer would have needed to pre-pay the taxes.  If tax rates are the same at the time of withdrawal as they were when money was deposited, this works out to be about the same. More details are available in this helpful article.

But consider this:

By having a mix of assets in a traditional and Roth accounts, the same couple could withdraw a mix of funds from both accounts, and still pay zero tax!

  • Imagine having half your assets in a traditional IRA or 401(k) plan, and the other half in a Roth account. By withdrawing $27,400 from the traditional IRA, and the remaining $72,600 from the Roth account, you have $100,000 to spend, free of Federal and California income taxes.

You always thought you had to pay taxes to take money out of your IRA, but with careful planning, some assets can be withdrawn from a traditional IRA every year, free of tax.

There are still more opportunities for planning to minimize the amount of tax we have to pay over the course of life.  There is a “zero capital gains tax bracket” in 2020.  When overall taxable income is $80,000 or lower (Married Filing Jointly), no federal income tax is due on realized long-term capital gains. This is not quite as beneficial as the above case, because it results in California income tax:

  • To have $100,000 available for post-tax expenses, realize $80,000 in gains in a taxable account, and withdraw $21,436 from a Roth IRA.
  • Taxable income is $80,000, is federal tax-free, and results in $1,436 California state income tax.

Qualified accounts turn growth that would be taxed as capital gains into taxable income. It should be clear by now that we do not want our pre-tax IRA or 401(k) balances to be so large that they will be subject to high income tax rates when Required Minimum Distributions begin at age 72.

Here is a sample calculation, using the RMD calculator at Required Minimum Distribution Calculator |  Each year’s RMD is calculated based on the prior year’s year-end combined account balance.

  • For a taxpayer at age 72, whose year-end balance is $700,000, the RMD is $27,343.75 (Married Filing Jointly).
  • If we can maintain the pre-tax balance of these accounts below this amount, a married filing jointly couple can avoid tax on their RMD because their standard deduction is currently $27,400.
  • The rules are complicated, so this example is overly simplified, but it illustrates the point that a careful IRA or 401(k) distribution strategy can be used to reduce, or even eliminate income taxes in retirement.

Note that a troubling thing happens to a surviving spouse.  When the first spouse dies, the second spouse must eventually file as a single person, with standard deduction of only $14,050 in 2020. Now, the same RMD is taxable because the surviving spouse’s exemption has been reduced. Now, the maximum balance to keep the RMD under the standard deduction is reduced to $359,000.

For this reason, married couples in retirement benefit the most if they can maximize distributions from their pre-tax accounts between their retirement (when they stop working) and before one of them passes, before they start taking Social Security, and before their required minimum distributions must begin at age 72. For many people this window is starts in the early 60’s (most common age for women is 63, and for men, 65, according to the Census Bureau).

Because of the way money is taxed at distribution, it takes careful planning to accumulate funds over one’s earning years to have a proper tax diversification. In fact, there is no single, simple rule of thumb to use.

Here are some ideas to best position assets for long-term optimal tax treatment:

  • When income is low, such as when someone is just starting out, there is less benefit to tax deferral. It is generally optimal to direct savings to Roth accounts. If someone is in the 12% tax bracket, but will retire in the 24% tax bracket, we can say that taxes will be lower over their whole life, by using the Roth.
  • When earnings increase, and sometimes when a two-earner couple will move into a higher bracket upon marriage, starting to make pre-tax contributions can be more beneficial.
  • If earnings drop, due to job loss for example, a person should consider stopping contributions to any pre-tax accounts. If there is some earned income, switching back to using Roth is probably best. (But never stop saving!)
  • When the pre-tax IRA or 401(k) balance tops $700,000, it may be time to consider paying the tax up front by switching back to Roth. This can continue all the way until the end of the working years. Roth conversions can be considered if the opportunity presents itself.
  • Some people have come to think that Roth accounts are fundamentally better than pre-tax accounts. The examples above have shown that this is not the case. If tax rates will be lower in retirement than in the working years, it is still better to use the pre-tax savings strategy.
  • In general, the best type of asset to hold in a pre-tax account is one that earns mainly interest. While rates are low today, they may not always be. Longer maturity bonds are a favorite here. This keeps pre-tax account balances from growing too rapidly. Additional savings can be invested in equities using other types of accounts.
  • In a taxable individual or joint account, low-dividend stocks, or tax-efficient stock mutual funds, are preferred. Gains can be deferred, and dividends are subject to favorable tax treatment.
  • International equities tend to have higher dividends than domestic equities. These go in Roth accounts, where the dividends are not subject to tax, and the gains are also tax-free.
  • Small-cap stocks can be expected to appreciate the most, over the long run. These belong in Roth accounts as well.

In this short post, we have only begun to scratch the surface of tax-optimizing strategies. The examples are extremely simple: most people’s tax situations involve itemized deductions, tax credits, and various set-asides such as flexible spending accounts. Another whole post could be devoted to how best to use Health Savings Accounts and 529 plans, to offset future tax burdens.

What makes this even more complicated? People change jobs, earn bonuses, sell homes, inherit, and ultimately, they die. This makes everyone’s tax situation unique, as unique as their own fingerprints.

The tax code is constantly changing. The SECURE act, passed in late 2019, made significant changes to how retirement accounts are taxed. More, and significant, tax proposals are about to be launched this year. Correctly applied, knowledge of the tax code can save you tens of thousands of dollars in taxes, by employing these, and other strategies, to your own situation.

Michael Garber Financial Planning specializes in serving technology professionals with stock compensation and related tax issues, in California and beyond. To contact Michael click here.

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