Tax-Savvy Retirement: Asset Location Explained
Maybe just converting all of the money you have in your IRA, if it's not too large of an amount, to your Roth IRA, and that will free up the ability to have a zero balance in your traditional IRA, which will then give you the opportunity to do backdoor Roths without any question or concern of the pro rata rule. Welcome to Retirement Answers, a podcast built to answer your most pressing retirement questions. If 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:So let's go ahead and get started with today's show. Hey friends, and welcome back to another episode of Retirement Answers. My name is Jacob Duke. I'm your host as always. Thanks for tuning into this week's episode.
Jacob:I hope you've been enjoying the show lately and it's been helpful for you on your retirement planning journey. So today I wanted to talk about taxes and I'm curious if you are wondering how you can save on taxes in retirement. You might hear about Roth conversions or other different tax strategies pretty often, but what if there's a simple way that you can reduce your annual tax bill without much extra work? Well, I wanted to talk through asset location with you and how it can help you enjoy a tax savvy retirement. So here's what we're gonna cover this week on the show.
Jacob:We're gonna talk about what asset location is. We're gonna talk about why it matters. We're gonna walk through a basic example of how this works logistically so you can kind of get an understanding of what we're talking through. Want to talk about some hidden benefits perhaps of doing asset location correctly. And then lastly, I wanted to answer a question that came in from a listener regarding backdoor Roth contributions.
Jacob:And it's something that I think many people overlook or are simply unaware of. So that's what we're going cover there at the end. So in terms of asset location, what is it? Well, it's simply whenever we want to align the investment type in terms of taxability of that investment type with the account type relative to that accounts taxability. So some of the building blocks we've got to understand here are gonna be how different account types are taxed, but then also how different investment types are taxed.
Jacob:So for example, a Roth IRA, once you put that money into that account, it grows tax deferred. And then once you reach two different stipulations, it could be tax free upon the distribution. So what are those two different stipulations? Well, first one is that you have to be 59.5 or older, and the account has to have been open for five years. Now that rule, the five year rule and that age rule, that has to do with the growth that has happened in the account.
Jacob:So it doesn't necessarily apply to all of the money. It only applies to a portion of it and that portion being the growth. Now, does that mean Jacob, I can access the money that I put into my Roth IRA over the years, regardless of how long the accounts been open or regardless of my age? And the answer is yes, you can take your contributions out of your Roth IRA at any point, regardless of whether or not those conditions have been met. It's really only the growth that we're talking about.
Jacob:And just to kind of go one step further here to kind of give you a little more education on this, whenever you take money out of a Roth IRA, you are always taking out your contributions first. Now that's regardless of your age. So for example, let's say you put in $20,000 into your Roth IRA over the last five years, and that now has grown to $30,000 Well, the $10,000 of growth, remember, that's not able to be touched or distributed without taxation or penalty until you are 59.5 and the account has been open for five years. But that 20,000 that you contributed, you could take that money out tomorrow regardless of your age or how long the account has been open because you put that in and whenever you take out money, you're taking from that 20,000 first, you're gonna take from the 10,000 of growth last. So that's just important things to know about distribution rules on Roth IRAs.
Jacob:Now, whenever we do meet all the different conditions regarding how or when we can take money from a Roth IRA without any tax or without penalty, that money would come out tax free. So when doing a Roth IRA correctly, what you're gonna do is you're gonna pay taxes on your money on the front end, whenever you put money into the Roth IRA, and you're gonna take that money out tax free in the future. That's why I call the Roth IRA the tax free bucket of any sort of investment portfolio or retirement planning portfolio. Now, a traditional IRA is the opposite. You do not pay your taxes on the front end whenever you put that money in, at least most of the time.
Jacob:You would deduct that off of your income whenever you contribute that to the account. So here in 2024, the annual contribution limit is $7,000 but if you are 50 or older, you can actually add another 1,000 on top of that, making your annual contribution 8,000 is the maximum. So whenever you do that, you are deducting that 7 or $8,000 off of your tax return in this year. Now I'm not gonna get into the different deductibility regulations on traditional IRAs. You may or may not actually be able to deduct your contributions from your income.
Jacob:Again, I'm not gonna get into that today because that's not the purpose of this, but we're gonna assume that you can deduct that. So let's say you deduct your contributions to your IRA. Well, whenever you take that money out of your IRA in the future, let's say in retirement and you're 59.5 or older, you will pay income taxes on the money you take out. So you're not paying tax on the front end, but you will on the back end. So those two accounts, the IRA and the Roth IRA, or think of it this way, a traditional four zero one ks and a Roth four zero one ks, your traditional four zero three b and a Roth four zero three b, those different account types are almost opposites of each other in terms of when you pay your taxes.
Jacob:Now there's this other third account type called just a normal brokerage account or a taxable investment account, whether it be an individual or a joint account, those are what we call taxable every year, meaning you're gonna get a $10.99 from the custodian that your account is held with, and they will tell you on that ten ninety nine, here's how much interest, here's how much dividends, here's any capital gains that you realize throughout the year. All those different items will be on your ten ninety nine, and that will tell you how or what you will pay taxes on in regards to the growth or the income that your brokerage account has produced throughout the year. So you will pay taxes annually on that specific account type compared to the IRA or the Roth IRA. Those you do not pay taxes annually, you either pay it on the front end or you pay it on the back end, but the account itself, the monies grow tax deferred while the account is open and the money is invested in that account. So you have three different kind of tax buckets.
Jacob:Think of it that way. You've got pre tax being the traditional IRA, you've got after tax being the Roth IRA, and then you have taxable being that third bucket such as a brokerage account. So those are the building blocks of what we have to know in this asset location conversation. Now, what's important to know is that the IRA, the pre tax account out of these three different ones, anytime that you distribute money out of that account in the future, it will always be taxed as normal income. Meaning regardless of the investment type in the account, whether it's a stock, a bond, or cash, or some sort of real estate fund, whatever it is, if it coming out of that IRA or that four zero one ks that's tax deferred, you will pay taxes on that as normal income on every dollar.
Jacob:So whenever we think about that, now we have to contrast this with different investment types. Stocks, bonds, cash, CDs, money markets, whatever you're investing in. We have to understand how these different investment types are taxed. So just to start with a basic example here, let's say we have a money market fund or a cash fund. Every year you're gonna receive some sort of interest payments by owning a money market holding.
Jacob:So now let's say you're getting 5% on your dollars that's invested in that money market holding. So every time you get paid that interest, you will pay tax on that interest as normal income, meaning it does not receive any sort of preferred treatment or lower taxation rates, almost as if you went to work and you earned it, that is the tax rate that you will pay on your interest from your money market funds. Now, the same thing is gonna apply for most bond funds or treasuries or different, fixed income assets. So you will get either dividends or you'll get interest depending on if you are holding your bonds through a fund or if you're holding them directly. But regardless, those will be what's called non qualified dividends or interest and that will still be taxed at a normal income tax rate.
Jacob:Now, difference is when we get to stocks. Stocks should pay you dividends because you were owning that particular company. So you get some sort of income that comes from your ownership of the company as well as potential growth that happens over time. The difference here is whenever you have dividends from a stock, most of the time, are gonna be what's called qualified dividends, which means they qualify for a different type of tax treatment. So let's talk through that briefly.
Jacob:Whenever we have qualified versus non qualified dividends, there are a couple of different rules to meet in order to get that preferred treatment. Most of the time, if you held a stock for an extended period of time, then you will get a qualified dividend, which means you will get a lower tax rate on that particular dividend compared to a dividend from a bond fund or interest from money markets or different holdings that you have that are fixed income. So what is this difference? Well, you have three different brackets that apply to qualified dividends and it's the same tax rates as a long term capital gain. And we'll talk about that in just a second, but those tax brackets are 0%, 1520%.
Jacob:Now every year, these different brackets in terms of which tax rate you're gonna pay, those are gonna be based on your income and they do inflate slightly every year along with the normal income tax brackets. But I'm not gonna get into the details of that today. In fact, I wanna give you a free deliverable that you can reference if you'd like to just shoot me an email. It's jacobrivertreewealth dot com. It's gonna be down in the description below.
Jacob:You can shoot me an email saying you'd like that important numbers information for 2024. I'll send that to you as soon as you request it, and then you can use that to your advantage. But this long term capital gain treatment or this qualified dividend treatment, will pay either a 0%, 15% or 20% tax rate on it at the federal level. What's important to know is that these tax rates are gonna be lower than whatever the normal income tax rate would be if you had a non qualified dividend. So it is advantageous for you to have qualified dividends or long term capital gains.
Jacob:Now, really quickly, you might know what a capital gain is, but let's talk really quickly about short term versus long term. Basically, you buy a stock or a stock fund, and then you sell it before you held it for three sixty five days, you will have, and you do have gains in it, you will have a short term capital gain versus if you held it for longer than three sixty five days, you would qualify for a long term capital gain rate, which means that you will pay a lower tax rate if you hold it for longer than one year. So a long term capital gain rate and a qualified dividend tax rate are gonna be the exact same rates. If you have a short term capital gain, it's gonna be as if you had interest on your holdings or a non qualified dividend. So whenever we think about this, how does this play into this overall conversation of asset location and basically aligning our account types with our investment types?
Jacob:So if we go back to a minute ago, whenever we're talking about account types, I said that every single time you take money out of a traditional IRA or a traditional four zero one ks, that money will be taxed as normal income no matter what. So if that's the case, and then we have investment types that are gonna have normal income no matter what, such as money markets or CDs or bond funds or different things that are fixed income. If that's gonna be taxed as normal income every time we receive interest payments or dividend payments for the bond fund category, or anytime we get interest off of a money market, if that's Taxed Normal Income, it would make sense that we have that specific investment type in the IRA or the pre tax account because every dollar that comes out of that in the future will also be, will be taxed as normal income. So what you're doing is you are aligning the tax type of the investment and how that money will be taxed with the tax type of the account. Here's why you do that.
Jacob:Let's say that you had a stock fund in your IRA or your pre tax account, such as a four zero one ks, and it grew by $20,000 and you held the investment for longer than one year and it was creating qualified dividends, let's say, on that stock holding. Well, whenever you go to take that $20,000 of growth out of that IRA in the future, it will be taxed as normal income, even though you held the investment for longer than a year and technically it could have qualified for a long term capital gain rate, which would have been cheaper than your normal income rate. So that's an example of how the tax treatment of the IRA actually hurts you whenever you hold stocks in that particular account type. Now, does that mean you shouldn't hold any stocks in your IRA? That's not what I'm saying.
Jacob:What I'm saying is we want to find a way to optimize this using your overall portfolio allocation. Now, if we go back to the brokerage account, which remember that's taxed annually on the dividends, the interest or the capital gains that are realized in the account. If we go back to that account, it would make sense that if it's taxed every single year, we want to find a way to lower that tax bill. So if we held money market funds and we got a 5% interest payment on that, every dollar of interest that we earned is going to be taxed as normal income because of the account type and it's gonna be taxed in that year. Talking about the brokerage account.
Jacob:Now, if we hold stocks in the brokerage account, you would likely be getting qualified dividends on your stock positions and you don't get taxed on the growth every single year. You only get taxed whenever you sell that particular investment and realize the gains on your investment. So you're gonna get dividends which will likely be qualified, but the growth that's happened in the investment itself is not gonna be taxed until you sell out of the investment, which remember, if you hold that for longer than one year, you would qualify for the long term capital gain treatment. And guess what? You have control over when you sell and when you don't.
Jacob:So that means you can hold it for longer than a year on purpose and you could benefit from that long term capital gain treatment. So the qualified dividends, you're gonna pay the taxes on that this year when those are earned. But the benefit of having that qualified dividend in your brokerage account versus IRA is that in the brokerage account, you're gonna pay a lower tax rate at the long term capital gain rate than you would at the IRA level. Whenever the IRA is distributed in the future, you'd pay normal income tax regardless. So hopefully this example shows you that it's important to understand how your investment types are gonna be taxed, but also how your account types are gonna be taxed, and then aligning those two things together to help you either lower your tax bill right now, but also potentially lower your tax bill in the future.
Jacob:I'm gonna talk more about some of those hidden benefits here in a second. And I haven't really talked about the Roth IRA very much, but but here's what you should know about it. If you have a Roth IRA, that should be one of your most aggressively invested accounts in theory, because that money will be growing at a tax free capacity for you in the future. So you wouldn't wanna hold all cash in a Roth. You wouldn't wanna hold bonds in a Roth because those of investments will not grow as much in theory over the long term compared to stocks.
Jacob:Stocks or real estate funds, whatever it might be, are gonna grow more over the long run. So therefore you should have that invested in your Roth. That way you can use the tax type of the account being tax free distributions of the future. You can use that to your advantage and have more money because you invested it more aggressively and you can distribute more money out tax free to yourself. So doesn't really get into that right there, but basically try not to hold the cash or bonds in your Roth.
Jacob:That's really the moral of the story. So let's look at an example really quickly. Hopefully it's somewhat realistic for some of you listening. You can apply these different principles across your situation, but let's just say that you've got $750,000 in an IRA, you've got 250,000 in a brokerage account, and you've got $200,000 in a Roth. So right around $1,200,000 total, and you're thinking about retirement, so your allocation is about sixtyforty, which is just a standard general rule of thumb investment allocation for retirees.
Jacob:Again, not going to get into the debate of if that's right or wrong, it's just I'm going to use that as an example. So one of the lazy ways of doing this, and I'm honestly shocked to see this more often than not, is to have a sixtyforty allocation across all three different account types. So you got sixtyforty in your IRA, you got sixtyforty in your brokerage, you got sixtyforty in your Roth, right? Because my allocation, I want it to be sixtyforty across the board, so I'm gonna invest each account type the same. Well, back to the reason for doing asset location correctly, is we would not want to have sixtyforty across the board because we'd have 40% of our money that's in Roth in bonds, which on $200,000 is a bunch of money we would have sitting in bonds or cash, not doing what it should be doing.
Jacob:Additionally, remember we have $250,000 in the brokerage account. And so if we've got 40% of that amount in bonds or cash or money market, that means that that is going to be taxed at a higher rate whenever we receive interest or dividends on those different holdings. So to lower your tax bill every single year and ultimately use the Roth IRA to your advantage, you'd probably wanna have all of that $200,000 in the Roth invested in stocks. And if you can, it's not always possible, but if you could in theory, you would have all that 250,000 in the brokerage account also invested in stocks. That way you get qualified dividend treatment, but also long term capital gain potential when you hold those investments longer than a year.
Jacob:So that would be $450,000 Now that doesn't make up the full 60% allocation of towards stock that you're trying to reach, which means the leftover amount of that 60% would have to be in your IRA. But the key is, is all of your bonds, all 40 of the bonds that you're trying to hold in your portfolio are in the IRA, which means every time you earn dividends or interest from those different fixed income or cash positions, you're not paying income tax on that money every year that it's earned, you only pay it in the future. And remember when you pay that in the future, it'll be on the amount that you distribute. So hopefully that example gives you an idea of how this kind of works in theory. If you're a sixtyforty portfolio across the board, you wouldn't hold sixtyforty in every single account type.
Jacob:You'd hold all stock hopefully in two account types and then whatever's left over out of your stock position that you need, that would be in your IRA and then all of your bonds or all of your fixed income or cash would be in the IRA to align itself with the tax type of the account. Now, what are some maybe hidden or other potential benefits of doing this correctly? Well, the first thing that's obvious is we've already talked about lowering your annual tax bill by reducing the amount of taxes you could have out of your brokerage account. Another thing that I've already talked about is increasing your tax free money in the Roth IRA by investing that more aggressively. But some of the hidden benefits of doing this correctly is lowering your RMDs or Required Minimum Distributions in the future.
Jacob:So you could focus on having more of your conservative assets in your tax deferred accounts, which means in theory you would have less growth over time, which means that your RMDs in the future at 73 or 75, those would not be as high as if you had invested more stock in the IRA. So some people, they don't pay attention to asset location and they end up building up a larger tax bill for themselves in the future because they didn't make these different small changes. So that's one huge benefit potentially is you could be growing your brokerage and growing your Roth more than your IRA, which helps you in the future for one reason being the Roth grows tax free. But then the second I'm gonna talk about the brokerage account. And then by doing so, you can reduce your RMDs by not investing as aggressively in the IRA.
Jacob:So it helps you save taxes in the future in that regard. And finally, a good way that this could help you out actually long term is if you end up not needing to spend all this money and you've got some fixed income sources, pensions, social security that you can use to fund your retirement lifestyle and you don't need to spend your actual portfolio. Whenever that brokerage account is passed on to the next generation, it receives what's called a step up in basis, meaning your heirs will not pay income taxes or capital gains taxes on the growth that's happened in the account. Your brokerage account essentially turned into a Roth account for them immediately because they're not gonna pay any taxes on that. Now, they would start paying taxes on it if they don't sell the investments upon your death and they let that keep growing.
Jacob:They would pay taxes on the growth that happens after your death, but all of the growth from whenever you invested in the brokerage account immediately and what it grew to, that is now tax free to your heirs. So that's a step up in basis. So again, you might not wanna hold money markets or fixed income products in your brokerage account if you can avoid it because your heirs would benefit more by having higher growth assets or investments in that particular account type. So hopefully this quick overview of what asset location is and how you can benefit from it annually, but also long term for both you and even your heirs down the road gives you some incentive to think through this and evaluate this for yourself. I often see that these things are overlooked or just not paid attention to whenever I'm evaluating portfolios for new clients.
Jacob:And so it's really simple for anyone to do. It's something that doesn't take a lot to go do. And I would encourage you to evaluate your portfolio, see where you can optimize this at least in some ways around what you're trying to do. And when you do that, you'll end up paying less tax every single year and perhaps benefit in the long term on these different items I just mentioned. All right, I mentioned a listener question that came in this past week around backdoor Roth contributions.
Jacob:And I wanted to go through that really quickly with you because I feel like it's something that often gets overlooked or just maybe misunderstood. So the question is, Jacob, I make too much money to contribute to a Roth IRA directly. So I'm trying to do a backdoor Roth contribution, but I have money in my traditional IRA. Can I still do a backdoor contribution? And the answer is technically yes.
Jacob:You can still do a backdoor Roth contribution, but you probably don't want to. Here's why. Whenever you are doing a backdoor Roth contribution in the first place, the reason for doing it is when you earn too much money to contribute directly to a Roth IRA in the first place. So nowadays that's becoming more and more common. But let's say you have money in an IRA like this person.
Jacob:They have $20,000 in IRA and they're like, Jacob, I still want to do a backdoor to get more money in the Roth. Can I do this? The answer is yes. You can do it, but you don't want to because there's this thing called the pro rata rule. So what is the pro rata rule?
Jacob:Well, if you're trying to do in 2024, let's say a $7,000 backdoor Roth contribution, you already have a $20,000 in your IRA. What ends up happening here is you could be creating a tax bill for yourself that you otherwise didn't think about. So in practice, a backdoor Roth contribution is whenever you add money to a traditional IRA and you don't deduct that contribution. So you make a non deductible contribution to your traditional IRA and then immediately quote convert it to your Roth. And the word convert just means pay tax.
Jacob:Now, follow me on this. You're not deducting it so you whenever you go to pay tax, you're technically not paying tax. So it ends up being a zero tax event, but it's just your way of getting money from your bank account into a Roth IRA whenever you earn too much to contribute directly to the Roth. That's why it's called the backdoor. Now that's simple whenever you have no money in a traditional IRA.
Jacob:But if you have money in traditional IRA, you can do a backdoor Roth contribution, but you're gonna create a tax bill for yourself because if you do the $7,000 into the IRA to do the backdoor Roth and you convert it to your Roth IRA, you're not converting all that $7,000 tax free like I mentioned earlier. Technically you now have pre tax money and post tax money in your IRA. And the pro rata rule says that whenever you distribute money out of your IRA, you have to do it in the appropriate proportions based on how much money is pre tax and how much money is post tax. Now this can get quite confusing here, so just follow me. The balance that the proportion of distribution is based on is the balance at the end of the year.
Jacob:So let's say we got $20,000 right now, we add 7,000 to it, and then we convert it, that 7,000 over to the Roth IRA, which leaves $20,000, let's say, at the end of the calendar year. So 7,000 of $20,000 is 35%, which means 35% of the 7,000 that you did the backdoor Roth with, that that 35% is the only part that is tax free. The other 65% of the 7,000, that is now taxable to you, right? Because all distributions out of an IRA, whenever you have pre tax and post tax money, they have to be done in equal proportions relative to how much is pre tax and how much is post tax. So this is often referred to as cream in the coffee.
Jacob:Once you kind of mix the two pre tax and post tax money in an IRA, you can't separate them, meaning they always have to come out in a blended fashion. So if you do have money in your Tax Deferred IRA and you try to do a backdoor Roth, just know that you're going create a tax bill for yourself by doing that because of this pro rata rule. So what would you do instead? Well, I would evaluate number one, do I have a four zero one ks that I can do a Roth four zero one ks contribution to? If I'm already doing that and maxing that out, and I'm trying to do a backdoor Roth on top of that, well, what you could think about doing is maybe just converting all of the money you have in your IRA, if it's not too large of an amount to your Roth IRA, and that will free up the ability to have a zero balance in your traditional IRA, which will then give you the opportunity to do backdoor Roths without any question or concern of the pro rata rule like we just talked about.
Jacob:So hopefully that makes sense hopefully that clears up some questions that a lot of people I think have and, it's helpful for you whenever you're thinking about backdoor Roth contributions. Okay. So remember that free deliverable I wanted to give to you. It's a cheat sheet basically for 2024 tax numbers and all the different things you can know about. If you want a copy of that, shoot me an email.
Jacob:It's jacobribertreewealth dot com. Happy to send that over to you. And then also if you have any different topics or questions that you want to hear about here on the show, go ahead and shoot me an email. Let me know what those might be, and I'd be happy to run through those and build some episodes around it. Because I think that ultimately my goal here is to serve you as a listener and talk about helpful things that you can use to your advantage.
Jacob:So again, if you're enjoying the show, please give a like rating review or five star review, whatever it looks like on the platform you listen to, and that'd be much appreciated so that other people can find the show and benefit from it just like you are. Thanks so much, and we will see you again right here next 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 jacobretirementanswers dot net. 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:Retirement Answers is for educational purposes only. Thanks for tuning into this week's episode. I look forward to talking with you again next week.
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