Do you have your assets in the right place for 2024?

My friend was shocked. “Do you mean I’ve underpaid my income taxes for 2023 and will have to pay a lot more when I file?”

“I’m afraid so.”

“And I could have avoided it just by paying more attention?”

“Yup. Sorry about that.”

Sadly, if you’re nearing retirement or retired, there’s a good chance you’ll make a similar discovery when you go to figure out your taxes this year. Your tax bill will have increased.

Higher interest rates, more taxable income

Why? Because millions of taxpayers have been asleep at the wheel about where they hold their financial assets.

The problem here is something financial planners call “asset location.” It’s not the same as asset allocation. That’s the decisions we make about the types of assets we buy such as equities, bonds, cash, real estate. Asset location is about what assets we keep in different types of accounts.

Asset location wasn’t a big problem for most of the past 20 years because interest rates were so low. But today, with short-term bond funds and money market funds yielding about 5%, it has become a big deal.

Making changes can now save you thousands of dollars in income taxes.

Each year.

You can see why “asset location” matters with a simple illustration. Let’s assume that you have $1 million in financial assets. That makes you a somewhat rare bird even though a million dollars isn’t what it used to be. You have half the money in a retirement account and half in a taxable account.

Investing long term in the retirement account, it was entirely committed to common stocks, every cent of it in a total domestic stock market fund because you’re a Couch Potato investor. You invested in short-term savings in the taxable account because you saw it as money you might need to access before retirement.

All quite logical and practical.

Until you think about taxes.

That was then, this is now

Today, the money in the taxable account is earning about 5%, or $25,000. That’s up from next to negligible in earlier years. But now your taxable interest income is substantial. And it is taxed as ordinary income.

Meanwhile, you’ve done well in your retirement account, which has soared with capital gains. Since it is a retirement account, those gains won’t be taxed until you withdraw the money, but they will be taxed as ordinary income when they are finally withdrawn.

Not very tax-efficient.

The solution is to change the location of your assets. First, invest in fixed income in the retirement account. The $25,000 is still earned but is deferred until you retire and start drawing on your retirement account money. That means no tax bill today.

(It’s also good to note that you can sell the equities in your tax-deferred account without creating what the IRS calls “a taxable event” because the account is tax-deferred.)

Meanwhile, you invest in equities in your taxable account. With the yield on the S&P 500 under 1.5%, this means your taxable dividend income would likely be no more than $7,500. That reduces your taxable income by $17,500. Better still, with qualified dividends typically taxed at 15%, you’ll probably pay less in taxes on the dividends than you would have paid on the same amount of interest income.

If you are receiving Social Security benefits, it’s possible that the same move will reduce the portion of your benefits that is subject to taxation, always a nice thing.

A caveat

While this is an optimal solution for tax purposes, it’s not all or nothing. Instead, you’d lean toward keeping fixed income in tax-deferred retirement accounts and equities in taxable accounts.

There are two good reasons for this.

First, taxable accounts are the easiest accounts to draw from in emergencies and involve no penalties for early withdrawal. So you’ll always have a cash reserve, even if it is only 10% or 20% of the account.

Second, since the long-term return on equities is higher than the long-term return on fixed-income savings, not holding equities in retirement accounts amounts to a voluntary reduction in your long-term investment return. That reduction could be worse than the higher tax rate you avoid.

This is a good place to remember that better is good, but perfect is the enemy of good.