This article is reprinted with permission from Esq. Wealth Management, Inc.
At EsqWealth, building wealth isn’t just about smart investments; it’s about making your money work as efficiently as possible through tax planning and asset location. By strategically placing the right assets in each tax bucket—taxable, tax-deferred, and tax-free accounts—you can not only reduce your overall tax burden, but also create essential flexibility for the future, helping you manage income effectively in retirement. This approach allows you to adjust your income in retirement to keep your tax rates low, regardless of changes in tax laws or market conditions.
In this article, we’ll demonstrate how effective asset location can optimize wealth through a hypothetical $6 million portfolio invested across bonds, stocks, and a high-turnover quantitative fund (“quant fund”). We’ll show how this strategy limits the impact of taxes on hard-earned wealth and offers more freedom to plan in retirement.
What is Asset Location?
Asset location involves placing each investment type into the appropriate account based on its tax consequences. Here’s a quick breakdown of the three buckets in which you can hold your assets:
- Taxable Accounts (e.g., brokerage or bank accounts): Investments here are subject to capital gains tax when sold, and interest or dividends are taxed annually. Generally, tax-efficient assets (like index funds or municipal bonds) are better suited here, as they generate fewer taxable events.
- Tax-Deferred Accounts (e.g., Traditional IRA, 401(k)): Investments grow tax-deferred until withdrawal, making these accounts ideal for tax-inefficient assets (like bonds and REITs) where you want to avoid annual taxation.
- Tax-Free Accounts (e.g., Roth IRA): Investments are made with after-tax dollars, and contributions, growth, and dividends can be withdrawn tax-free in retirement. This makes high-growth assets (like small-cap growth stocks and startups) well-suited here, maximizing tax-free gains.
The Peter Thiel Example: Billions of Tax-Free Growth
Paypal cofounder Peter Thiel made a remarkable return by utilizing an asset location strategy. He owned his PayPal shares in his Roth IRA when the company was still a start-up, and the shares were valued at pennies. Over time, those shares grew exponentially as PayPal became one of the largest payment platforms in the world. Thanks to the tax-free nature of a Roth IRA, Thiel was able to shield all of those gains from taxes, turning what began as a small investment into a tax-free fortune of over $5 billion.
The takeaway from this example is that high-growth assets like early-stage startups or small-cap stocks can grow tax-free inside a Roth IRA. If these same investments had been held in a taxable or tax-deferred account, Thiel’s tax burden would have been potentially in the billions of dollars.
The Power of Asset Location: $6 Million Portfolio Hypothetical
While you might not expect returns like that of Thiel, let’s apply this asset location strategy to two hypothetical investors Homer Simpson and Fred Flintstone with hypothetical returns. They each start with a $6 million portfolio with the same exact mixture of bonds, stocks, and a quant fund but placed in the three different buckets mentioned above. The goal is to see how proper asset location can optimize after-tax wealth, and how holding the wrong assets in the wrong accounts can cost millions.
To briefly elaborate on what a quant fund involves, EsqWealth works with Johnson Dunn Capital Advisors which manages several portfolios including a quant fund. The quant fund eliminates emotional biases from investing by employing a proprietary quantitative analysis model. The model narrows down approximately 2,500 companies based on industry, valuation, and mathematical measures. The portfolio is regularly rebalanced in the short term, generating short-term gains which are taxed at ordinary income rates (assumed to be 50% here, including state and federal taxes) as opposed to long-term capital gains which are currently taxed at a lower rate.
Homer Simpson’s Portfolio: A Tax Tragedy
Homer’s approach to asset location is a little “D’oh!” He places his assets in less-than-optimal locations, creating a portfolio even Ned Flanders might wince at:
- Roth IRA: Homer puts $2 million of after-tax dollars invested in bonds, which grow at a meager 4% annually into his Roth IRA.
- Traditional IRA: Homer’s $2 million of after-tax contributions (assuming his income levels prevent pre-tax contributions) is invested in a mixed portfolio of bonds and equities, growing tax-deferred at 6%.
- Taxable Account: Homer puts $1 million in small-cap stocks (11% growth) and $1 million in a quant fund (15% growth) in his taxable account.
After 20 Years of Growth:
- Roth IRA (Tax-Free): Homer’s bonds grow at 4% to approximately $4.38 million, tax-free but underwhelming.
- Traditional IRA (Tax-Deferred): Homer’s mixed portfolio grows to about $6.41 million, with $4.41 million taxed at 50%, leaving him around $4.205 million after taxes.
- Taxable Account (Already Taxed):
- Small-Cap Stocks: Growing at 11%, the stocks reach about $8.06 million, taxed at 20%, netting Homer about $6.45 million. (For mathematical simplicity, these calculations assume the stocks are held for 20 years and do not consider taxable dividends.)
- Quant Fund: Growing at 15% but taxed every year at 50%, Homer’s $1 million only grows to around $4.248 million. Because the 15% gains are taxed every year at 50%, his after-tax gain is only 7.5% each year.
Total After-Tax Wealth for Homer: About $19.47 million. Not bad, but let’s see how Fred fares with the same assets.
Fred Flintstone: Yabba-Dabba-Done Right
Fred Flintstone may live in the Stone Age, but his asset location strategy is nothing short of modern genius. By placing the same high-growth assets in tax-free accounts, Fred avoids Homer’s tax pitfalls and ends up in financial Bedrock bliss.:
- Roth IRA: Fred stashes his $2 million of small-cap stocks growing at 11% and the quant fund growing at 15% into his Roth IRA, all growing tax free.
- Traditional IRA: Fred keeps his $2 million in bonds here, growing at 4%.
- Taxable Account: Fred’s remaining $2 million invested in a balanced mix of bonds and equities, growing at 6%, is placed in this bucket.
After 20 Years of Growth:
- Roth IRA (Tax-Free): Small-cap stocks grow to about $8.06 million and the quant fund grows to about $16.37, resulting in a tax-free total of $24.43 million.
- Traditional IRA (Tax-Deferred): Bonds grow to approximately $4.38 million, with $2.38 million of growth taxed at 50%, leaving $3.19 million.
- Taxable Account (Already Taxed): The balanced portfolio at 6% grows to $6.41 million, with the $4.41 million gain taxed at 20%, netting around $5.53 million.
Total After-Tax Wealth for Fred: About $33.15 million. Fred’s smart planning leaves him sitting on a nest egg far larger than Homer’s, with a tax bill that’s small enough to roll out the welcome mat for Dino.
By strategically placing high-growth, tax-inefficient assets like the quant fund in his Roth IRA, Fred Flintstone outsmarts Homer and ends up with a portfolio that’s $13.67 million richer after taxes.
The Value of Maintaining All Three Tax Buckets for Tax Flexibility
Aside from allocation, there’s also value in insuring that each of the three buckets—taxable, tax-deferred, and tax-free—has assets allowing retirees to have more control over their retirement income and the ability to manage their tax bracket.
Our goal as an advisor is to help you manipulate your tax bracket strategically. Imagine you need $500,000 per year to live on in retirement, and tax rates are at 50%. If all your retirement funds were in your 401K or traditional IRA accounts, you’d owe $250,000 in taxes on that $500,000. However, if you have assets spread across all three buckets, we have options.
For example, we could take:
- $100,000 from Tax-Deferred, taxed at 50%,
- $200,000 from Tax-Free (Roth IRA), with no tax due, and
- $200,000 from Taxable, with no tax due as it has already been paid.
By drawing from all three buckets, you could reduce your total tax bill from $250,000 to just $50,000. The next year, if tax rates change, we could adjust your income sources accordingly.
We can’t predict future tax rates, but we can help you avoid surprises by ensuring you have options when things change. With assets in each tax bucket, you’ll have the flexibility to react to market and tax conditions. Our approach ensures that you can adapt, making the most of your hard-earned wealth no matter what retirement brings.
Conclusion
A tax-efficient portfolio can add millions to your wealth over time, but the benefits go beyond tax savings. By planning strategically and maintaining assets in all three tax buckets, you gain flexibility in retirement, empowering you to adjust your tax bracket as your needs and tax laws change. Following the example of investors like Peter Thiel—who maximized tax-free growth—and keeping high-growth assets in tax-free accounts, along with a balance in taxable and tax-deferred accounts, can give you more control over your financial future.
With EsqWealth, you’re not just building wealth but ensuring it’s positioned for flexibility and resilience. Reach out to us to learn how we can help optimize your portfolio for long-term growth and adaptability in retirement.
The information above is not intended to and should not be construed as specific advice or recommendations for any individual. The opinions voiced are for general information only and are not intended to provide, and should not be relied on for tax, legal, or accounting advice. To discuss specific recommendations for any unique situation, please feel free to contact us.