Maximize Your Retirement Income With Tax Location Optimization

Hello everybody, my name is Ty Bernicke and today I’m going to be talking to you about maximizing your retirement income with tax location optimization and tasks. Location optimization is defined as allocating your investments in a tax efficient manner to minimize your lifetime tax burden, and to help optimize your long term wealth. And to understand what this means, it’s first important to understand the three different tax buckets that I have in front of you.

The Three Tax Buckets

Tax-Deferred Bucket

And again, I apologize if you’ve seen my YouTube videos before, because I always have to explain this, but it’s extremely important for a lot of the concepts and strategies that we go over. So imagine for a second, if you had to take all of your investments and you had to place them into one of three buckets, we’ve got the tax deferred bucket, which would include things like IRAs and 401 K’s and 403 B plans and 457 B plans.

When you put money into this bucket, it goes in on a tax deductible or our pretax basis, which means you save in taxes and the year that you put the money in and it grows tax deferred. However, when you retire and take money out of this bucket, generally 100% of what you take out as income in the year you take it out is subject to ordinary income tax.

Tax-Free Bucket

So a lot of tax advantages upfront, but a lot of tax disadvantages in the long term where when you contrast that with the tax free bucket, which would include things like Roth IRAs, Roth 401 K’s and other Roth related retirement plans, you don’t get a special tax break when you put money into this bucket. Initially, however, the money grows tax free and you can take it out for qualified reasons in the future, income tax free.

And if you don’t want to take money out of this bucket during your lifetime, you don’t have to. And so this has a lot of tax advantages down the road, especially in retirement. When you take the money out.

Non-Qualified Bucket

The third bucket is what we call the non-qualified bucket. Generally you don’t get any special tax breaks when you invest into non-qualified investments, which essentially means non retirement. Non not IRA not a 401 K. So that’s what we call non-qualified. And depending on the types of investments that you put your money into, you might have to pay tax on capital gains, dividends interest income that you earn. But the initial amount that you invested, let’s say you invested 100,000 into this non-qualified bucket. You would be able to take that $100,000 out income tax free, because you theoretically should have already paid the tax on that money.

You’re not going to have to pay that tax twice, at least, at least not yet according to the tax laws, because that would be very unfair.

Measuring Tax Efficiency of Investments

So one of the things that’s important to know about the non-qualified bucket is not all investments are created equal. And there’s a way to actually measure, mutual funds tax cost ratio. And there’s a company called Morningstar that actually does this. And generally speaking, what that tax cost ratio does is it tells you, how much money as a percentage of your return will be lost to taxes on an annual basis and a very tax efficient mutual fund.

You might only lose 0.3% of your return on a very, very expensive one. You might lose up to 5% would be about as extreme as I’ve ever seen. So that doesn’t happen a lot. But it’s not uncommon to see a tax cost ratio of 1 or 2% a year. And that can make a significant difference over the long term.

Doesn’t sound like a lot on a one year basis, but if you look at it over the course of a retirement, it’s a pretty big deal. But generally speaking, things like individual stocks, especially growth stocks, passively managed ETFs or index fund ETFs, ETFs stands for Exchange Traded Fund, which is essentially a lot like a actively managed mutual fund or like a passively managed mutual fund.

And municipal bonds can be quite tax efficient. But you got to be very careful. Municipal bonds might be tax efficient for some people, but very tax inefficient for others. But generally these speaking, these things have lower cost ratios, lower tax cost ratios where on this side things like high income bond funds actively managed mutual funds, balanced mutual funds that are diversified between stocks and bonds.

Allocating Investments Across Tax Buckets

Those would be on the tax inefficient side of things. And so when we’re looking at allocating investments, it’s okay to own all of these. But you don’t want to own the highly taxed ones in the bucket where they’re really going to get penalized. You might want to own them in the tax deferred or the tax free bucket, where you don’t have to worry about the annual burden of taxes.

But this is so important. I thought, why don’t we do an example to kind of illustrate how big of a difference this can make? Because when we see new people that come into our firm, nine times out of ten, they’re owning investments in that non-qualified bucket that should not be there because of their tax inefficiency.

Example: The Impact of Tax Cost Ratios

But let’s just assume for conversation. Say we have somebody that has a $500,000 in the non-qualified bucket, and their current tax cost ratio is 1.5%. And we recommend more tax efficient investments for this bucket. And on that investment, we we get that expense ratio or the tax cost ratio down to 0.7 5%, which is very reasonable to do over a 30 year time horizon.

That $500,000 earning an 8% rate of return would go to 3.0, a little over 3.1 million with the current tax cost ratio. But if you lower that tax cost ratio just a little bit, the value of the portfolio actually increases by over $700,000 through that one little change. So making sure you own the right investments in the right buckets is extremely important.

This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

Balancing Tax-Deferred and Tax-Free Growth

Now, if we were to extend this conversation even further, and now that we’ve talked about the non-qualified bucket, let’s focus a little bit more on the tax deferred and the tax free buckets. Now when you think of this, this bucket in the future when you withdraw it and you’re going to be forced to withdraw it at a certain age, either 73 or 75, depending on your date of birth.

Well, all that money that comes out is going to be subject to taxation. With this bucket. None of the money is going to be subject to taxation. So if you have investments that you expect to grow more in the future, like stock accounts and other investments that you expect to not grow as quickly in the future, but are more dependable over the short term.

Things like bond accounts. Where do you want to place those stocks and bonds? If you put all your stocks here and all your bonds here, wouldn’t it make sense that you’d be growing your tax burden here and minimizing your good tax bucket? Absolutely. So generally speaking, when we look at the timing of when people are taking their money out and the tax implications of their decision, we want to put more of the growth investments in the bucket.

And that’s growing tax free. And the more conservative investments that we expect to not grow as well in this bucket over here, the tax deferred bucket, all things being equal. Of course there are many nuances to this. But generally speaking that’s a rule that we use at our office because we want to make sure that we’re growing the tax sanctuary bucket as much as as we can and minimizing the bad bucket.