April 13, 2023

BALANCE SHEET DIVERSIFICATION

by Austen Hawkey,  CPA, CFP®

Asset Allocation is a vital aspect of the wealth management industry and for good reason. An often overlooked component of a sound financial plan is balance sheet diversification, also known as asset location. Balance sheet diversification means having various assets that are treated differently for legal and/or tax purposes based on the ownership or titling. There are three types of investment accounts I will focus on to help achieve balance sheet diversification.

Taxable accounts are funded with after-tax money and are taxed each year on the dividends, interest and realized capital gains. Qualified dividends and realized long-term capital gains within these accounts receive preferential tax treatment which are less than the federal ordinary income tax rates. For example, in 2023 a married filing jointly filer with total taxable income between $89,251 and $553,850 will have a 15% long-term capital gains rate. The ordinary income tax rates within that income range are between 22 - 35%.

Tax-Deferred accounts, such as 401(k) and IRA’s, are funded with pre-tax money meaning you have either received a deduction, tax credit, or did not paid taxes on the money funding the account(s). Furthermore, the dividends, interest, and capital gains are not taxed annually allowing the account(s) to defer the tax until a later date. The initial investment, as well as, any dividends, interest, and capital gains will be taxed at ordinary income tax rates when the funds are taken out of the account. In addition, the IRS says these funds cannot stay in the account forever and the account owner will be required to take a percentage out once they reach a certain age known as Required Minimum Distributions (RMDs).

Tax-Free accounts, such as Roth 401(k) and Roth IRA, are funded with after-tax money like the taxable accounts but their dividends, interest, and realized capital gains are not taxed annually. If certain requirements are met, dividends, interest, and capital gains are not taxed upon withdrawal like the tax-deferred accounts. Keep in mind there are limitations on who can contribute to a Roth IRA, and the Roth 401(k) option wasn’t available until 2006 and isn’t available in all employer sponsored plans.

So, why is asset location a critical consideration in financial planning? We’ve explored how the tax treatment of three types of accounts varies. Diversification among the asset types allows for flexibility to meet income needs and, with proper tax planning, can keep more money in your accounts and less going out for taxes in retirement. To illustrate this, let’s compare two hypothetical scenarios.

Scenario 1:  We’ll assume an individual who saved for retirement through their company’s 401(k) plan. This individual decided to save solely in the company sponsored 401(k) and by the time they reached age 73 had accumulated $2,000,000 for retirement.

Scenario 2: We have the same individual, however, instead of solely saving within the 401(k) plan this individual took a more balanced approach to saving and was able to accumulate $1,000,000 in the 401(k) plan, $500,000 in a taxable investment account, and $500,000 in a Roth IRA. So, this individual has the same amount, $2,000,000, saved for retirement but has diversified the funds among 3 different types of accounts that are treated differently for tax purposes.

My assumptions are as follows: age 73, filing status of single, no dependents, claims the standard deduction, receives $35,000 in social security, and is not subject to Alternative Minimum Tax. Table 1 demonstrates the differences for a side-by-side comparison.

To compare the scenarios in Table 1, Scenario 2 has an estimated tax liability that is $5,557 less than Scenario 1. While Scenario 1 has $22,736 in additional income, Scenario 2 has the advantage of tax efficiency to narrow the income gap. Scenario 2 has the option of taking a tax-free withdrawal from the Roth IRA and/or realizing long-term capital gains in the taxable investment account. In this scenario, the long-term capital gains rate is 15% and only applies to the gain portion of a sale (sale proceeds less cost basis). For example, stock that was purchased for $15,000 is sold for $24,000. The gain of $9,000 is taxed at 15% resulting in a tax liability of $1,350. This is still well below the estimated tax liability in Scenario 1. Another consideration is how income impacts Medicare premiums. Roth IRA distributions are not included in income-related monthly adjustment amount (IRMAA) which can potentially decrease Medicare premiums depending on where an individual’s income is in relation to the thresholds.

The outcomes of my example are not intended to discourage people from saving for retirement within tax-deferred accounts, and it does not take into consideration the tax savings that were realized when making contributions. Tax-deferred accounts are a great option for most people, especially when an employer provides matching contributions. However, tax-deferred accounts should not be the only investment asset on your balance sheet. Having balance sheet diversification allows for greater flexibility and tax diversification when you need those assets to support your lifestyle. Whether you are in the accumulation or distribution phase, having a comprehensive financial plan can help you gain tax efficiencies and benefit you in the long run.—A. Hawkey