Understanding asset location: the value of tax-free assets in retirement

When planning for retirement, one of the most important strategies to consider is how you place your investments across different types of accounts. This strategy is known as asset location, and it can significantly impact your tax efficiency and, ultimately, how much money you have to spend in retirement. In this article, we'll explain what asset location is, explore the different tax-free assets you can own, and discuss the many benefits of having these assets as part of your retirement plan.

We'll also walk through an example that compares a traditional 401(k) with a Roth IRA or a life insurance policy, using the highest tax bracket and considering state taxes to illustrate the potential impact on your finances.

What is asset location?

Asset location is a strategy that involves choosing the right type of account for each of your investments to minimize taxes. It’s different from asset allocation, which focuses on spreading your investments across different categories like stocks, bonds, and real estate, etc, to reduce risk. With asset location, the focus is on where you hold these investments - whether in taxable accounts, tax-deferred accounts, or tax-free accounts.

For example, some investments, like bonds or mutual funds that generate a lot of taxable income, might be better placed in a tax-deferred account like a traditional IRA or 401(k). On the other hand, investments that are more tax-efficient, such as index funds or stocks, might be better suited for a taxable account where you can take advantage of lower long-term capital gains taxes.

The Power of Tax-Free Assets

One of the most effective ways to use asset location to your advantage is by including tax-free assets in your retirement plan. These assets allow your investments to grow without the burden of taxes, giving you more flexibility and control over your retirement income. Here are some of the most common tax-free assets:

• Roth IRA: With a Roth IRA, you contribute after-tax money, but your investments grow tax-free, and you can withdraw the money in retirement without paying any taxes. This means that once you’ve paid taxes on the money you put in, you never have to worry about taxes on those funds again

  
  

• Roth 401(k): A Roth 401(k) works similarly to a Roth IRA, but it’s typically offered through your employer and allows you to contribute more each year. Like a Roth IRA, your contributions are made with after-tax dollars, and your withdrawals in retirement are tax-free.

  
  

• Life Insurance: Certain types of life insurance, such as permanent life insurance (which includes whole life and universal life policies), allow you to build cash value that can be accessed tax-free through loans or withdrawals. Additionally, the death benefit is usually tax-free to your beneficiaries.

  
  

• Health Savings Account (HSA): An HSA offers triple tax benefits: contributions are tax-deductible, the account grows tax-free, and withdrawals for qualified medical expenses are also tax-free. In retirement, an HSA can be a valuable resource for covering healthcare costs without the need to pay taxes.

  
  

Why Tax-Free Assets Are So Valuable in Retirement

Tax-free assets provide several important benefits that can make a big difference in your retirement:

1. No Required Minimum Distributions (RMDs): Traditional IRAs and 401(k)s require you to start taking money out when you reach age 73, even if you don’t need it. These withdrawals are called required minimum distributions (RMDs), and they’re taxed as ordinary income. However, Roth IRAs and life insurance policies aren’t subject to RMDs, allowing your money to keep growing tax-free for as long as you want.

   
   

2. Flexibility in Income Planning: Tax-free assets give you more control over how and when you take money out of your retirement accounts. Because you don’t have to pay taxes on withdrawals, you can access your money without worrying about jumping into a higher tax bracket or triggering penalties.

   
   

3. Efficient Tax Management: When you withdraw money from a Roth IRA or life insurance policy, it doesn’t count as taxable income. This can help you manage your overall tax situation, avoid additional taxes on your Social Security benefits, and even prevent Medicare surcharges.

   
   

4. Estate Planning Benefits: One of the key benefits of tax-free assets, such as Roth IRAs and life insurance policies, is the favorable tax treatment they receive when passed on to beneficiaries. When a Roth IRA is inherited, the beneficiary can withdraw funds without owing federal income taxes, as long as the account has been open for at least five years. While the beneficiary must start taking required minimum distributions (RMDs) based on their life expectancy, these distributions remain tax-free. 

   
   

Similarly, the death benefit from a life insurance policy is typically received by the beneficiaries free of federal income tax. This means that your loved ones can inherit these assets without the burden of taxes, preserving more of the wealth you’ve built over your lifetime. However, it's important to be aware that state estate or inheritance taxes may still apply, depending on where you or your beneficiaries live.

These taxes vary by state, so it’s essential to include them in your estate planning considerations to ensure that your heirs can fully benefit from the tax advantages of these assets.

Comparing a traditional 401(k) with Roth ira or life insurance

To see how tax-free assets can impact your retirement, let’s compare a traditional 401(k) with a Roth IRA or a cash value life insurance policy. Imagine you have $1,000,000 in a traditional 401(k) and another $1,000,000 in a Roth IRA or life insurance policy.

Traditional 401(k)

A traditional 401(k) allows you to contribute pre-tax dollars, meaning you don’t pay taxes on the money you put in. However, when you withdraw money in retirement, you pay taxes at your ordinary income tax rate. Let’s assume you’re in the highest federal tax bracket, which is currently 37%.

• Federal Taxes: If you withdraw $100,000, you would owe $37,000 in federal taxes, leaving you with $63,000 to spend.

  
  

• State Taxes: Many states also tax retirement income. If your state tax rate is 5%, you would owe an additional $5,000 in state taxes, reducing your net withdrawal to $58,000.

  
  

• RMDs: Once you reach age 73, you’ll be required to start taking RMDs from your 401(k), whether you need the money or not. These RMDs are also subject to taxes, potentially increasing your tax burden as you age.

  
  

Roth IRA or life insurance

Now let’s look at the Roth IRA or life insurance policy. Both of these options allow your money to grow tax-free, and withdrawals are also tax-free.

• Federal Taxes: If you withdraw $100,000 from a Roth IRA or life insurance policy, you keep the entire $100,000. There are no federal taxes due.

  
  

• State Taxes: Most states do not tax Roth IRA withdrawals or life insurance policy loans or withdrawals. This means you keep the full $100,000, with no taxes taken out.

  
  

The impact of taxes on your retirement income

As you can see from the example above, the difference in tax treatment can significantly impact your retirement income. With a traditional 401(k), your withdrawals are reduced by taxes, meaning you have less money to spend. In contrast, with a Roth IRA or life insurance policy, every dollar you withdraw is yours to keep, giving you more spending power in retirement.

State taxes: a critical factor

While federal taxes are often the main focus, state taxes can also have a significant impact on your retirement income. State tax rates vary widely, and some states do not tax retirement income at all, while others tax it at high rates. When planning for retirement, it’s essential to consider the state where you plan to live and understand how its tax laws will affect your income.

For example, if you live in a state with a high income tax rate, like California (which has a top rate of 13.3%), the impact on your 401(k) withdrawals could be substantial. In our earlier example, with a 37% federal tax rate and a 13.3% state tax rate, a $100,000 withdrawal from a 401(k) would leave you with just $49,700 after taxes - less than half of your original withdrawal.

On the other hand, if you live in a state with no income tax, like Florida or Texas, your Roth IRA or life insurance withdrawals would be entirely state tax-free, and will only be taxed on the federal level. 

Simplifying your retirement plan with asset location

Asset location isn’t just about minimizing taxes - it’s about creating a retirement plan that’s simple, flexible, and tailored to your needs. By strategically placing your investments in the right accounts, you can reduce your tax burden, increase your income, and enjoy a more comfortable retirement.

Here are a few key takeaways to keep in mind:

• Start early: The earlier you begin thinking about asset location, the more time you’ll have to optimize your strategy. Consider contributing to tax-free accounts like Roth IRAs or purchasing life insurance while you’re still working and in a lower tax bracket.

  
  

• Diversify your tax strategy: Don’t rely on just one type of account. By spreading your investments across taxable, tax-deferred, and tax-free accounts, you’ll have more flexibility in retirement and be better prepared to manage your tax liability.

  
  

• Review your plan regularly: Tax laws and your personal situation can change over time, so it’s important to review your asset location strategy regularly. This will help ensure that your retirement plan continues to meet your needs and takes advantage of any new opportunities for tax savings.

Asset location is a powerful tool for managing your taxes and maximizing your retirement income. By understanding the benefits of tax-free assets like Roth IRAs and life insurance, you can build a more efficient and flexible retirement plan that keeps more of your money working for you.

Whether you’re just starting to save for retirement or you’re already retired, taking the time to optimize your asset location strategy can pay off in the long run, giving you the financial security and peace of mind you deserve.

Have questions, schedule your no-obligation consultation here.

Sources*:

IRS

Morningstar

U.S. News & World Report - Money

The Balance

*These organizations are not affiliated with IFG. IFG does not endorse, support, or recommend any information that is not provided by its affiliates or representatives.

Disclaimer:

Information provided is for informational purposes only, and does not constitute an offer or solicitation to sell, a solicitation of an offer to buy, any security or any other product or service. Accordingly, this document does not constitute investment advice or counsel or solicitation for investment in any security. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.