Retirement Answers

Jacob: 00:01

So if different investments are taxed different ways and different account types are taxed in different ways, how you invest in each account type is gonna matter. This is where asset location comes into play. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If you're someone who's either thinking about retirement or already in retirement, well, you're in the right place. Hey there, my name is Jacob Duke, and each week I'll be walking through different tips and strategies to help you succeed in retirement.

Jacob: 00:34

So let's go ahead and get started with today's show. Hey everybody, and welcome back to another episode of Retirement Answers. This is Jacob Duke. And as always, we've got great topics and content for you as, someone who's thinking about retirement or who already might be in retirement. We've all heard of diversification for our investments.

Jacob: 00:56

And if you listen to me for some time, you've probably heard me talk about tax diversification. Where basically we're saying, hey, wanna have money in different tax buckets. We wanna have money in our traditional IRAs, our Roth IRAs. We wanna have money in that taxable investment account because that gives us the flexibility to choose where we want our income to come from whenever that retirement rolls around. So today I wanted to talk about something, that most people overlook within their investment portfolios, and it's the idea of asset location.

Jacob: 01:23

So this is in addition to our tax diversification that we always talk about and also in addition to diversification within our investments. So what is this thing called asset location? Well, it's the idea of thoughtfully investing in certain investments within certain account types. So here's what I mean. Different investments, they have different tax implications and different account types are taxed differently.

Jacob: 01:46

Asset location is aligning those two things to help minimize your tax bill each year. So this is stuff that everyone can do. And after today, you'll know how to do this. What's frustrating about it is that most people overlook this. And I actually see many advisors not paying attention to this when it comes to asset location, and therefore they're costing their clients a lot of money in taxes.

Jacob: 02:06

So before we walk through an example of this, we have to remind ourselves of a few things. We have to know what ordinary income is. We have to know what qualified dividend income is. We have to know what long term capital gains are and how the rates and income taxes apply to those different items. So these different types of income or capital gains, they're all taxed differently and for different reasons.

Jacob: 02:27

Ordinary income is the type of income that you get from your job or from rental properties. Anything you do to earn money by working is ordinary income. Qualified dividend income is income that comes to you as a dividend from an investment and it has to meet certain criteria. The IRS has two different categories of dividends and how they define them. There's ordinary dividends and there's qualified dividends.

Jacob: 02:51

Well, to be a qualified dividend, you have to be investing in a stock or a stock fund, to get qualified dividends. There are different mutual funds, ETFs, and REITs, real estate investment trusts out there. They all pay dividends, But depending on the underlying investments, whether they're invested in stocks, bonds, money markets, things like that, or treasuries, that will dictate how those different funds are gonna be taxed. So to be a qualified dividend from a mutual fund, it has that mutual fund has to be investing in stocks. It cannot be investing only in bonds or cash or money markets.

Jacob: 03:25

It has to be investing in the investment of stocks. In addition to having to be a stock or an equity fund or ETF, you have to have purchased that investment and held it for sixty one days or longer. There's a little bit more to this, but I don't want to get into all the weeds. There's ex dividend dates involved and the timing of your purchase that matter. But in general, if you hold your stock investments for the long term, whether it be individual stocks or mutual funds or ETFs that are invested in stocks, those dividends will always be qualified.

Jacob: 03:55

So stock and stock mutual funds are able to have qualified dividends and bonds and money markets are not. So how does this affect how they are taxed? Well, qualified dividends are going to be taxed at long term capital gain rates, which is more beneficial than short term capital gain rates. And right now, term capital gain rates are either zero, fifteen or 20% depending on your income. And if you're one of those high earners that are out there, you could also have this thing called net investment income tax that might be applied on top of your long term capital gain rates.

Jacob: 04:26

And that tax is 3.8% on top of the 20 capital gains rate. Now, most people don't fall into that category. The reality is, is most Americans fall into that 15% capital gains rate bracket, and that's based on income. So what does all of this matter? Well, if we know that stock dividends can be treated as a long term capital gain, and we know that stock gains can also be treated as a long term capital gain if we held it for longer than one year.

Jacob: 04:52

Those are the most tax efficient investments because bond dividends and interests will always be taxed as normal income rates. And normal income rates are always gonna be higher than long term capital gain rates. Now bond funds, they can be sold after one year, like if you held that bond fund for more than one year, they are eligible for that long term capital gain treatment because you held the actual investment for longer than one year, but the dividends, the interest that come in along the way, those are always gonna be taxed as normal income. So in general, bonds are going to create a higher tax bill because of all the income that comes from bonds is gonna be considered those short term capital gain rates, which is also taxed as just normal ordinary income. Whenever we think about how these different tax types of investments are taxed, it would be really wise of us to consider how different account types are taxed as well.

Jacob: 05:40

For example, a traditional IRA is tax deferred and every dollar taken from that account in the future will be taxed as ordinary income. There's no way around it. You're gonna always be taxed as normal income whenever you take money out of a tax deferred account, like in a traditional IRA or a traditional four zero one ks. A Roth IRA on the other hand is always after tax, meaning you paid your tax originally when you put the money into it. Therefore, if you meet the distribution rules of the Roth IRA that has to be met, you'll be able to take money from that account in the future tax free.

Jacob: 06:12

And then there's the taxable investment account. You've heard me talk about this one a lot if you listen to the show for any length of time. This account type is taxable on an annual basis. Not when you take the money out of the account, but any year that you have dividends, interest or capital gains that are coming into the account, they're subject to taxation that year. If you have this account type, you'll receive a $10.99 each year, regardless of if you took money out or not.

Jacob: 06:35

Remember, because we have to pay taxes on the interest, dividends, or capital gains that are incurred throughout the year. So that ten ninety nine will outline those taxes that you owe and why you owe them. So if different investments are taxed different ways and different account types are taxed in different ways, how you invest in each account type is gonna matter. This is where asset location comes into play. So for example, you wouldn't want all of your cash or money market in your Roth IRA.

Jacob: 07:01

Why not? Well, because the growth that takes place in that account type will be tax free one day. Therefore, we want that account to grow as much as possible. So more growth in the Roth IRA means more tax free money. So it would not be as wise to put bonds or money markets or or slower growth fixed income type assets in that Roth IRA.

Jacob: 07:19

So stocks or equities are gonna be the thing that you want to invest within that Roth IRA so that you have the the greatest odds to have the most growth potential. A traditional IRA, on the other hand, is gonna be taxed as normal income. And no matter what in the future, whenever you take money out of that account. So it's tax deferred currently. Whenever you take money out in the future, it will be taxable as normal income.

Jacob: 07:39

There's no way around this. Whenever you take money out, you're gonna pay that income tax. And it's gonna be taxed the same as if you were taxed on a paycheck from work. Because of this, you would want to invest in things that are gonna be taxed as normal income as well. So bonds, CDs, money markets, real estate investment trusts, REITs, all these items have interest in dividends that will come out to you as the investor because you're holding the investment.

Jacob: 08:02

And those dividends and interest will always be taxed as ordinary income or a short term capital gain. So using these types of investments within your IRA aligns the tax type correctly with the tax type of the account. And finally, the taxable investment account should be invested in things that create as little dividends or interest as possible and also in the investments that can qualify for long term capital gains. So what would this be? This would be stocks and stock mutual funds or ETFs.

Jacob: 08:30

We can sell them in the future for a long term capital gain once we've held them for longer than one year. And then also the dividends that come in from these investments, as I mentioned earlier, they would be qualified dividends, meaning they're gonna be taxed at that lower rate of zero, fifteen or 20%. What would not be optimal in terms of investing within that taxable investment account would be to invest in bonds, CDs, money markets, or any other fixed income type assets within that account. As we've learned, these investments have interests and dividends that will always be taxed as normal income, which is always gonna be higher than long term capital gain rates. So also these fixed income and cash investments, they create more dividends than stocks do.

Jacob: 09:07

They just create more income in general. That's what they're designed to do. Stocks are gonna, yes, they're gonna create dividends for you, but they're designed to grow in in terms of asset appreciation. Fixed income products, money markets, CDs, and bonds, they're not necessarily designed to grow very much in terms of appreciation. They're designed to spit off income to you as the investor in more of a fixed way.

Jacob: 09:30

So in a perfect world, your taxable investment account and Roth IRA are where your stock holdings would be and perhaps should be. And the traditional IRAs where your bonds and money markets and more fixed income type assets should be. So this is called asset location and it helps you lower your tax bill annually. But a question you might be having is, well, but Jacob, I'm supposed to have a fiftyfifty portfolio, but how am I supposed to do this? Well, that's a great question.

Jacob: 09:54

And the mistake I see most people have and even advisors is they're they're allocated $50.50 in every one of their account types. So they're fifty fifty in their Roth, they're fifty fifty in their investment account, they're fifty fifty in their IRA. And this is an easy way to do it, but like we've learned, it's gonna cost you more in taxes. So as an example, let's just say that you've got $1,000,000 and currently that $1,000,000 is broken down between 500,000 in your traditional IRA, 250,000 in your investment account, and then $250,000 in your Roth IRA. Each of those different accounts, they're invested $50.50 across the board because that's the target allocation.

Jacob: 10:29

So within your investment account, you've got 125,000 in stocks and 125,000 in bonds. Within your Roth, you've got 125 in stocks, 125 in bonds. Within your traditional IRA, you've got $2.50 in stocks, $2.50 in bonds. That's the fiftyfifty split across the board. So that's the easy way of doing it.

Jacob: 10:46

The more tax efficient way of doing it is to have 250,000 invested in stocks in both the investment account and the Roth IRA, and then have 500,000, which is the full amount within your traditional IRA, have that invested in bonds, cash and money market. So you're still at an overall allocation of $50.50 like we want, but we're doing it in a tax efficient way. Now I'm just using a fifty fifty allocation to kind of get the point across. I wouldn't say that a fifty fifty asset allocation is what most people should be doing, but you get the idea. So how you invest in different account types matter.

Jacob: 11:16

And I think I'm gonna plan on diving into this a little bit deeper with actual numbers and data to show you in another episode, how this can actually impact your tax bill each year in dollars. So, when you think about it, asset location is kind of only possible whenever you have tax diversification. And once again, tax verification, that's having savings and investments in three different primary account types. Tax deferred, like your traditional IRAs, your traditional four zero one k's or four zero three b or TSP. Then you also have your tax free, which would be your Roth IRAs, Roth TSP, Roth four zero one k, Roth four zero three b, and you have your taxable normal just brokerage your investment account.

Jacob: 11:52

So you need to have a plan for how you're gonna get tax diversified. And then as you're doing that, you need to be aware of the asset location that we just talked about and how you're investing in each of those different account types. So if you find these different types of strategies and tips helpful, please give the show a rating and review. It really helps others find the show when more people are giving it a good rating, and it helps me know that I'm providing really good content. So thank you so much for tuning into this week's episode of Retirement Answers.

Jacob: 12:18

I look forward to talking with you again next week. Hey, it's Jacob again, and I wanted to extend a quick offer to you. If you have a question and you would like to have it answered here on the show, please email me at jacob. Dukeappliedcapital dot com, and I'd love to answer that question for you right here on the show. Also, I wanted to remind you that nothing discussed in today's episode is meant to be financial, legal, or tax advice.

Jacob: 12:42

Retirement Answers is for educational purposes only. Thanks for tuning in to this week's episode of Retirement Answers. I look forward to talking with you again next week.