Maintaining an optimal after-tax asset allocation becomes more difficult as withdrawals are made, but research provides useful guidelines.
Two common investor objectives are typically addressed with two well-accepted industry practices. First, to minimize taxes on portfolio income and gains, tax-inefficient assets (i.e., investments that generate higher taxes, such as taxable fixed income) are placed in tax-favored retirement accounts. Second, to preserve the compounding of tax-free returns for as long as possible, retirees fund their spending from taxable accounts before withdrawing from tax-favored retirement accounts.
While relatively straightforward, these strategies can eventually conflict with another important objective: optimal portfolio diversification. In practice, if all or most tax-efficient assets are held in taxable accounts and liquidated first to fund withdrawals, an investor’s portfolio will increasingly be weighted toward tax-inefficient assets rather than an optimal mix of assets. On the other hand, investors who seek to avoid this issue by withdrawing from both taxable and tax-favored retirement accounts — and/or rebalancing toward tax inefficient assets as withdrawals are made from retirement accounts — risk sacrificing optimal after-tax returns.
So which strategy should investors favor? Is it more important to hold tax-efficient assets in taxable accounts (i.e., “asset location”) or delay withdrawals from retirement accounts to maximize the benefits of tax-free returns (i.e., “withdrawal sequencing”)?
Research from Peter Mladina, Northern Trust’s director of Portfolio Research, provides important findings for those facing this conundrum or simply questioning how best to fund expenses in retirement. Using a common, efficient mix of four major asset classes commonly owned by high-net-worth investors, his analysis suggests the following:
- To the extent possible, investors should practice asset location while prioritizing optimal asset allocation as their main objective.
- Asset location is likely most beneficial to those individuals who do not plan to consume their retirement assets during their lifetimes.
- Withdrawal sequencing — withdrawing from taxable accounts first — should be prioritized by investors who plan to consume their tax-favored retirement accounts during their lifetimes.
- In practice, a combination of asset location and withdrawal sequencing could make sense.
Steps for spending and investing in retirement
These findings provide useful insight, but you may question how to apply them to your unique situation — particularly if you do not know whether you will need to consume your retirement assets during your lifetime. To apply this insight to your portfolio, we suggest working with your financial advisor to accomplish the following:
Understand how much and when you will withdraw from your investment accounts.
We believe the best way to achieve this clarity is through a goals-driven approach, which matches your financial assets with your anticipated expenditures to create a better portfolio for you. This process begins by identifying and prioritizing your life goals, which is ultimately the insight you will need to employ optimal asset allocation, asset location and withdrawal sequencing.
Determine the assets and investment strategies best suited to help you fund your goals.
At Northern Trust, this process uniquely results in discrete asset allocations for specific goals you wish to fund, which adjust over time along a “glidepath.” It’s important to note that if you have a Roth IRA, you are not required to take distributions during your lifetime, which sometimes warrants treating it as its own entity for asset allocation purposes.
Employ asset location.
This generally includes placing taxable investment grade bonds, high yield bonds, real estate investment trusts and hedge funds in tax-favored accounts, while placing tax-exempt municipal bonds and tax-efficient stocks in taxable accounts. Keep in mind, however, that liquidity is also an important part of the equation. Sometimes this may mean placing less tax-efficient assets, such as high quality bonds, in taxable accounts for the purpose of avoiding early withdrawal penalties (from retirement accounts) or needing to sell stocks at depressed prices in the event of a market downturn. At Northern Trust, we use a Portfolio Reserve to help make these decisions.
Work with your financial advisor pre- and post-retirement to optimize your withdrawal strategy.
If you determine that you will not need to consume your retirement assets beyond your required minimum distributions, you will likely choose to prioritize asset location and, in turn, optimal after-tax portfolio diversification, as you spend from and rebalance your accounts.
Continue to look for tax planning opportunities offered by your portfolio.
For example, keep in mind that stocks are generally tax-efficient not only because of the relatively low income they generate. They also provide the potential for tax loss harvesting as well as tax-efficient charitable giving. For more tax planning opportunities — beyond those offered by your portfolio — refer to our 2020 Year-End Tax Planning Checklist.
Taking the above steps may seem complex, particularly if you have already undergone a traditional financial planning process that has proven cumbersome without providing sufficient clarity. However, our goals-driven approach is different. It allows you to easily evaluate tradeoffs and make more confident decisions about your asset allocation and overall financial plan.
For more information, please contact one of our advisors. And for more detail underlying the research discussed above, please read Asset Location and Withdrawal Sequencing.