In the last article, we looked at the three buckets that make up most retirees’ financial lives: taxable, tax-deferred, and tax-free. The idea was simple: stop thinking about your retirement as a collection of separate accounts and start thinking about it as one integrated system.
That leads to the next question — and it’s one of the most important questions you can ask before making an investment decision:
Which bucket should own this investment?
Most investors never ask it.
They decide what they want to own first and then figure out where to put it. If they have room in an IRA, they put it there. If they have cash in a brokerage account, they buy it there. If the 401(k) offers the investment, they use the 401(k).
That’s understandable. It’s also incomplete. The same investment can produce a very different after-tax result depending on which bucket owns it.
The Investment Is Only Half the Decision
Imagine you’ve decided that you want to own a particular stock, bond fund, REIT, or other investment.
The traditional question is:
“Is this a good investment?”
That’s an important question.
But once you’re approaching or living in retirement, there’s another question that deserves equal attention:
“Where should I own it?”
That question matters because your accounts don’t all follow the same rules.
A dividend-producing investment may generate taxable income every year in a taxable account. The same investment held inside a tax-deferred account may not create a current tax bill. And an investment held in a Roth may potentially grow without creating federal income tax on qualified withdrawals.
Same investment.
Different bucket.
Different consequences.
This is why asset location, the decision about where to hold different investments, can be an important part of retirement planning.
Start With the Tax Characteristics
One useful way to approach the decision is to consider what the investment naturally produces.
Some investments are relatively tax-efficient. Others can generate substantial taxable income or short-term gains.
For example, a broad-market stock index fund held for the long term may be relatively tax-efficient in a taxable account because much of its return may come from unrealized capital appreciation.
A high-income bond fund can be different. Its interest income may be taxable each year when held in a taxable account.
Real estate investments can create yet another set of considerations.
The point isn’t that one type of investment automatically belongs in one particular bucket. EXCEPT never, never, never own a municipal bond or fund in a tax-exempt account. Because the interest on the Muni bond is already tax free, it doesn’t need to be in a tax-free vehicle.
The point is that the tax characteristics of the investment should be considered alongside the tax characteristics of the account.
That is the beginning of asset location.
The Taxable Bucket: Flexibility Has Value
The taxable bucket often gets treated as the leftover account - the money that remains after you’ve maxed out your retirement plans. That can be a mistake.
For retirees, taxable assets can provide something other buckets may not provide as easily: flexibility.
There are generally no retirement-plan withdrawal restrictions simply because you’ve reached a certain age or haven’t reached one yet. You can sell an investment when you need the money, use the proceeds for a major purchase, fund a retirement expense, or create a source of cash flow.
And because taxable accounts are subject to capital-gains rules rather than ordinary income treatment for every dollar withdrawn, there can be opportunities for tax planning.
That doesn’t mean every investment belongs here.
It means you should recognize that the taxable bucket itself is an asset. Flexibility has value.
The Tax-Deferred Bucket: Don’t Forget the Tax Bill
Traditional IRAs and many employer retirement plans have been enormously valuable accumulation vehicles.
But there’s an important catch:
The money isn’t necessarily tax-free. You’ve generally postponed the tax.
Eventually, withdrawals from traditional retirement accounts are generally taxable as ordinary income, subject to the applicable rules.
That means a dollar inside a traditional IRA isn’t necessarily economically equivalent to a dollar in a Roth IRA or taxable account. This becomes increasingly important as retirement approaches.
If you have $500,000 in a traditional IRA and $500,000 in a Roth, you don’t necessarily have $1 million of equivalent after-tax spending power.
The tax characteristics are different. That difference should influence how you think about the investments held inside each account.
The Roth Bucket: Your Most Valuable Tax Real Estate?
For many retirees, the Roth bucket can be particularly valuable because qualified withdrawals are generally tax-free at the federal level. That creates an unusual planning opportunity.
You may not want to think of your Roth simply as another account containing investments. You may want to think of it as tax-free real estate.
Once you’ve paid the tax to get money into the Roth, future qualified withdrawals can potentially avoid another federal income-tax bill. That can make the Roth especially valuable as part of a long-term retirement strategy.
But again, there is no universal rule that says, “put your highest-return investment in your Roth.” That may be appropriate in some situations and inappropriate in others. Your tax bracket, time horizon, estate-planning objectives, withdrawal needs, risk tolerance, and the characteristics of the investment all matter.
There Is No Universal “Best” Bucket
This is where retirement planning gets more interesting — and more personal. Suppose you own a stock that you expect to hold for 20 years. Where should it go?
Now suppose it’s a bond fund generating substantial interest income. Same question.
Now suppose it’s a highly appreciated stock that you don’t intend to sell. Again: which bucket should own it?
The answers may be different - and that’s the point.
Asset location isn’t about finding a magic formula that works for everyone. It’s about recognizing that the location of an investment can be part of the investment decision itself.
Think About the Household, Not the Account
This brings us back to the bigger idea behind the three-bucket framework.
Your retirement doesn’t care which account generated the money.
When you need $50,000 to pay for your lifestyle next year, you don’t experience that withdrawal as “IRA money” or “brokerage-account money.”
You experience it as $50,000 of household spending.
The challenge is to determine which combination of accounts and investments can provide that spending in the most sensible way over time.
That means looking at the entire household. Maybe your taxable account is best positioned to provide spending during certain years. Maybe your traditional IRA provides another source of income. Maybe your Roth is preserved for later retirement, when flexibility and tax-free withdrawals become particularly valuable.
The answer will depend on your circumstances. But the important thing is to have a reason for the arrangement.
The Better Question
This is why I believe retirement investors should ask a slightly different question before every major investment decision.
Don’t simply ask:
“Should I own this?”
Ask:
“Should I own this — and if so, which bucket should own it?”
That second question forces you to think beyond investment selection. It makes you consider taxes, flexibility, future withdrawals, time horizon, and the role the investment is supposed to play in your retirement. And that is the larger lesson.
Investment selection answers what you own. Asset location answers where you own it. Retirement planning requires thinking about both.
You don’t need to memorize the tax code to begin thinking this way. You simply need to stop looking at your accounts as separate boxes. They’re pieces of the same retirement.
And sometimes, the most important decision isn’t what you buy.
It’s where you put it.
This article is provided for general educational and informational purposes only and should not be considered individualized investment, tax, or legal advice. Every investor’s circumstances are unique. Readers should consult appropriate professionals regarding their specific situation before making financial decisions.
Thanks for reading The Ward on the Street! Subscribe for free.