Asset Location and Making Your Money Last in Early Retirement
My pal Dr. James Turner at The Physician Philosopher likes to write about the 20% you need to know to achieve 80% of the results in personal finance. He even wrote a book detailing that 20%; I recently read it on vacation and I highly recommend it.
Here at Physician on FIRE, we spend a fair amount of time exploring the other 80% you might want to understand to eke out the most optimal results. Today, we’ve got one such post, and it deals with asset location for a model early retiree.
Note that asset location and asset allocation are not the same thing, and our author explains that difference. Today’s post was written by Dr. David Graham, who shared with me the following bio:
David Graham, MD, is a practicing Infectious Disease physician and blogs at FiPhysician.com. After discovering his passion for personal finance, he started a Registered Investment Advisory to promote his mission of “Financial Literacy for Physicians.” For personal enjoyment, he recently sat for and passed the CFP exam.
Asset Location and Making Your Money Last in Early Retirement
The debate rages on: Bonds go in your taxable!
The White Coat Investor and Physician on FIRE don’t agree on everything.
For those pursuing early retirement, who are we to believe?
Does asset LOCATION, how you distribute your desired asset allocation in your always taxable (IRA and 401k), sometimes taxable (brokerage), and never taxable accounts (Roth), influence your net worth in early retirement, or is it much ado about nothing?
Bogleheads has a nice Wiki on asset location, but one may be left slightly confused after a thorough reading. “It is best to understand the basic principles and then apply them to your situation.”
Another quote from the Wiki is revealing:
“The situation may change in retirement, when the funds are withdrawn for income (decumulation phase). It is possible under some combination of lifetime investing results and lifetime individual tax situations to be better off doing the opposite of the strategy recommended here.”
Well, that helps.
What would PoF do in early retirement? Let’s look at his portfolio and find out!
When asked, PoF suggested a solid asset allocation for early retirement. His actual portfolio is more complex and nuanced (as is real life), but he suggested the following (and I’ve added expected future returns):
- 50% US Total Stock Market (7%)
- 10% Developed International Stocks (7%)
- 10% Emerging Markets (8%)
- 10% REIT (8%)
- 20% Total US Bond Fund (3.5%)
Of course, if the expected future returns of asset classes were known, we would all be rich and not need to worry about asset location. Generally, however, over long periods of time, you might have higher average returns from Emerging Markets and REITs than from US and International funds, which all usually have higher average returns than bonds.
REITs kick out K-1 income, which is taxed as ordinary income rather than at the more favorable capital gains or qualified dividends rate–more on this below including the 20% QBI deduction. Interest from bonds is also taxed as ordinary income. REITs and bonds share a tax disadvantage and portfolio placement should be carefully planned.
In addition, PoF has three types of accounts to consider: he suggests we distribute his portfolio 50% in brokerage, and 25% each in an IRA and a Roth IRA. (Excellent retirement tax diversification).
So, how should an early retiree locate or distribute his funds in his different accounts?
The Scenario for Early Retirement
Assume the early retiree is 44, married, and working for 5 more years. After retirement, let’s follow the portfolios for 15 years to see the effect of asset location on net worth in early retirement. Retirement income is taken from the brokerage account, and the IRAs grow in the background for future use.
At 44, they have $2,000,000 in assets with 50% in their brokerage account, 25% in a rollover IRA, and 25% in their Roth account after aggressive (and perhaps ill-timed) conversions.
Working part-time, they earn $120,000 for the next 5 years and then will retire and live off of the accumulated nest egg. They spend about $80,000 a year, approaching a 4% withdrawal rate.
Income increases 2% per year, and inflation sits at 2.5% overall and 5% for healthcare.
Asset Location Models
Let’s look at the next 20 years for this couple given three different asset location models. (Download the spreadsheet to enter your own info)
Figure 1 (Good location model)
The first model named “Good” asset location has bonds and REITS in the tax-deferred accounts and invests most aggressively in the Roth account.
Figure 2 (Even location model)
The second model “Even” has even asset location between the three account types
Figure 3 (Poor location model)
The third model dubbed “Poor” has the least tax efficient funds (bonds and REITs) in the brokerage account.
The Results Are In
Let’s see how these plans perform over time.
Figure 4 (Asset simulation)
Figure 4 shows simulated assets with confidence levels over our 20-year investing timeline. Results from all three models are similar, so the Even asset location model is shown.
Figure 5 (Withdrawal rate)
Withdrawal rate (again shown for the Even asset location model) in figure 5 starts at 3.7% and increases with inflation. It is 3.8% after 20 years.
Cash Flow Analysis
So how do our plans perform in the first decade? First, let’s look at tax efficiency via cash flows from the Good and Poor asset location plans.
Figure 6 (Cash flows for Good asset location)
Figure 7 (Cash flows for Poor asset location)
As we can see in Figures 6 and 7, income and expenses are the same (expenses go up in retirement to account for health insurance starting at $10,000 a year).
Tax payments are quite different between the two models. In the first 5 years, taxes cost $178,606 for the Good (tax-efficient) portfolio and $215,243 for the Poor (tax-inefficient) portfolio. The Even asset location plan (data not shown) splits the middle and pays $198,403 in taxes.
Net flows initially are positive for the Good plan and negative for the Poor, but note they are very similar by 2030. Tax payments are also similar by then. We will see why later.
Account Balance and Net Worth After 20 Years
So how do the plans do after 20 years? Let’s find out.
Figure 8 (Good, Even, and Poor asset location model account balances)
As seen above, the balance in the brokerage account grows more at retirement in 2025 in the Good and Even plan than in the Poor plan. It is then spent down in all plans, all the way to zero in the Poor plan.
The IRAs grow in the background. They grow equally in the Even plan. In the Good plan, however, the Roth IRA is invested much more aggressively and grows substantially more. Make note of this, as further discussion follows.
After 20 years, the total balance is ~$4.2M in both the Good and Poor plan, and $4.0M in the Even plan.
We can now see why the tax liabilities are the same in the Good and Poor asset location plans by 2030. The brokerage account in the Poor plan not only suffers from higher initial taxes, but also lower yields from the bonds. By 2030, asset levels are low enough that despite ordinary income liability, taxes are equal to the higher, more efficient, Good asset location plan.
Does Asset Location Matter in Early Retirement?
So, what can we learn about asset location in early retirement?
If you have other income, tax liability increases when the brokerage account is loaded with tax-inefficient funds. In this example, this amount is $36,637 over 5 years. Over 20 years, however, there is no difference in the size of the retirement assets. An even distribution of portfolio allocation leads to a ~5% decrease in retirement assets compared to the other plans.
While taxes need to be considered in proper asset location, higher expected returns drive the truly important results. Returns matter–and returns compound over time. Especially consider expected returns in your tax-deferred and tax-free accounts, but note that stuffing your Roth is not a free lunch.
As an example of the difference due to higher expected returns, revisit figures 1 and 8. The Roth IRA in the Good asset location plan compounds to more than two times the traditional IRA, thanks to the fact that 80% of funds pay 8% vs 80% bonds paying 3.5%. This 4.5% spread doubles in 16 years (using the rule of 72), which accounts for the large difference. Again, returns matter.
Bonds and REITs
Let’s look more closely at a few obvious fund choices when considering asset location.
Bond interest is tax inefficient and taxed as ordinary income. Bonds also have low rates of return compared to other asset classes. So why have bonds? Bonds offer portfolio diversification and dampen volatility. Especially peri-retirement, bonds decrease sequence of return risk and may allow better sleep. You invest in bonds because they are part of your planned asset allocation, and you locate them where they do the least harm vis-à-vis their low expected returns.
REITs are tax inefficient as well, but are expected to have higher returns over time than bonds. REITs pay K-1 income, which is taxed as ordinary income. Prior to the Tax Cut and Jobs Act of 2017, it made a lot of sense to own REITs in tax-sheltered accounts to avoid ordinary income. Section 199A (the Qualified Business Income 20% pass-through deduction) changed the math for REITs, however, as you can deduct up to 20% of the K-1 income from your brokerage account as QBI. All in all, still, REITs belong in tax-sheltered accounts.
Other examples of potentially tax inefficient funds are actively managed funds with short term capital gains, commodity funds, target date funds, and small cap value funds.
Additional Early Retirement Considerations
A few other issues must be addressed. Obviously, this simplified scenario doesn’t consider partial Roth Conversions, capital gain harvesting (or the 0% tax rate for qualified dividends in the bottom two tax brackets), or the standard deduction. If adjusted gross income is less than the $24,000 standard deduction for married filing jointly, no tax is paid regardless of the income source.
Additional issues with asset location depend on your mix of taxable vs tax-deferred accounts, FIRE maneuvers like the 72(t) SEPP or Roth conversion ladder, and, of course, when the money is needed.
Real life circumstances, such as limited investment selections in 401k, 403b or 457 plans, affect all portfolios. In addition, consider the rebalancing challenges if you only have certain asset types in specified accounts. For instance, with small cap value in a Roth and the total market index and bonds in a brokerage account, how does one rebalance after a 10-year bull market?
Should I Worry About Asset Location?
Asset allocation trumps asset location for the retire early crowd, as savings rate trump both when you are just starting out.
So, what should someone planning early retirement do?
The big picture: start with asset allocation. What percentage of bonds are you comfortable with? What tilts may potentially juice your returns? REITs and emerging market index funds are tilts in this scenario, but other considerations are small caps, value funds, sector funds, etc.
Then consider asset location. First, place your high-return tax-inefficient assets in your tax-deferred accounts. Next, place your high-return tax-efficient assets in your brokerage accounts. Finally, low return assets (like bonds) fill in the remaining voids.
Sounds like WCI and PoF both got it right. As seen after 20 years of PoF’s fictional portfolio above, where you put bonds doesn’t much matter if you get the big picture right.
[PoF: Well, I’m relieved to here I was right. Or not wrong, at least.
One thing I’d like to point out that Dr. Graham alluded to is the fact that the “poor” model does leave you with a similar amount of total money as the “good” model. However, there is a heck of a lot more still in the tax-deferred IRA (by ~ $850,000) and a lot less in the Roth IRA (~ $200,000 less) and the taxable account in the “poor” model is depleted.
Taxes will continue to affect the “poor” model much more than the “good.”
In my most recent portfolio update, I had about 48% in taxable brokerage, 18% in tax-deferred, 23% in Roth, a smidge in an HSA, and about 11% in crowdfunded and other investment real estate (also taxable investments).
With the tax-deferred portion representing under 20% of my retirement nest egg, I can safely say to most people, “My Money Is Worth More Than Your Money.“]
Where do you keep your bond allocation? How important do you think asset location is to your overall investment and retirement plan?