Good financial advisers and smart investing DIYers have something in common when it comes to building a portfolio.
They both put a high priority on risk tolerance and how it applies to asset allocation.
After all, a diversified blend of stocks, bonds and cash is the well-established path to reaching your retirement goals. It helps you grow and protect your nest egg and retire with the money you need … right?
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Well, yes. But if that’s your only focus, you’re likely neglecting another crucial piece of long-term portfolio planning: tax efficiency.
I see people, even some financial professionals, make this mistake all the time. They determine risk tolerance — often with an in-depth risk assessment tool — then go for a stock-bond mix based on the suggested asset allocation.
And that’s it. They’re investing and growing their money as comfortably, and safely, as possible. Or so they think.
Unfortunately, they haven’t put much thought into how those investments will be taxed when they retire and start drawing income from their savings. All too often they’ve created a tax trap inside their tax-deferred IRA.
That’s bad enough, but when I see an investor whose portfolio includes taxable and tax-deferred accounts that mirror each other exactly, it really makes me scratch my head. When it’s a retiree with a large nest egg or a high income-tax rate, I just want to jump in and fix it.
The problem? That investor is growing her IRA and, therefore, her required minimum distributions (RMDs). Those mandatory withdrawals, which begin at age 70½ whether you want them or not, will be taxed as ordinary income — the highest tax rate.
But she doesn’t have to do it that way if she also has a taxable account, which doesn’t have RMDs and offers other advantages for handling the growth in her portfolio, including tax harvesting possibilities and profits that are taxed at the lower capital gains rates, instead of as ordinary income.
Here’s a hypothetical: Let’s say our investor, Sandy, is 70½ years old and has $500,000 in her IRA and $500,000 in a taxable brokerage account. For the next 20 years, she plans to take only her RMDs and let the rest of her investment savings compound. She wants her money to grow, but not by putting it at too much risk, so she fills out a risk assessment questionnaire that tells her to use a 50%-50% blend of stocks and bonds.
Sounds pretty simple. Except that Sandy puts the exact same blend of investments in both her IRA and brokerage accounts. That could cost her thousands of dollars, thanks to the effect taxes will have on her returns (not to mention the likelihood of duplicate management fees).
Sandy was off to the right start worrying about risk and determining which specific stocks, bonds and other investments best met her portfolio needs. But she (or her adviser) should have taken it a step further by looking at those investments and assigning them to either her IRA or brokerage account based on how they’re taxed.
Her strategy could have been to place her more conservative investments (those with lower expected returns) in her tax-deferred IRA and her more aggressive (higher-earning) assets in her taxable brokerage account or a Roth IRA. Each account still would have been working hard for her but in very different ways. The conservative funds in her IRA would fill her need for safety, and as they grow more slowly, the higher tax rate wouldn’t take as big of a bite. Meanwhile, the more aggressive funds in her taxable brokerage account would grow more quickly, but be taxed at a lower rate.
If, like Sandy, you have the same or a similar blend of investments in your accounts, it’s probably going to cost you. But if you coordinate your accounts instead, you can cut your tax liability considerably.
I believe managing taxes in retirement (and pre-retirement) is just as important to financial success as choosing the right investments. If you don’t have the time or inclination to research the tax consequences of your investments yourself, find a trustworthy CPA or financial adviser to help you out.
You’ve worked hard to build your nest egg. Don’t lose that money to a mistake.
Kim Franke-Folstad contributed to this article.
Investment advisory services offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and RightBridge Financial Group are not affiliated companies. Investing involves risk including the potential loss of principal. Any references to protection benefits or lifetime income, etc. generally refer to fixed insurance products, never securities or investment products. Insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. AW06172999
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