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One Thing Investors Can Control

Christine Benz

Christine Benz: Hi. I'm Christine Benz for Morningstar.com here at the Morningstar Investment Conference. Managing a retirement portfolio for tax efficiency and for optimal tax management is a big piece of the retirement planning process, but it's also an under-recognized one.

Here to share some insights on this topic is Christine Fahlund. Chris is the senior financial planner and also a vice president at T. Rowe Price. Chris, thanks so much for being here today.

Christine Fahlund: Thank you. My pleasure.

Benz: So let's talk about some ways to think about tax management, and the nice thing about it is that it's something that investors really can control, as opposed to a lot of the other pieces of the retirement planning process. So let's talk about some tips for getting the most out of retirement assets with proper tax management.

Fahlund: Okay. Well, for one thing, you know, when you are accumulating money, the taxes don't matter as much because you're going to be saving in tax deferred accounts primarily, and so what is there to worry about? But when you think about it a little further, you realize that once you get into a retirement, it's a whole different ballgame because every time you withdraw assets from an account, they are probably going to be taxable events.

Benz: Unless they are Roth assets.

Fahlund: Unless they are Roth assets. So – if we start with the understanding that that's inevitable, that we're going to end up with taxable events, then let's start, while you are in accumulation, diversifying your accounts so that you don't simply end up with one tax-deferred IRA, for example, rollover, but instead, you have some money in taxable accounts and you have some money in Roth IRAs.

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Benz: Right. So the idea is that the investor gets tax diversification just like you might have asset class diversification or investment style diversification. It's just another way to kind of protect yourself against a multitude of different scenarios.

Fahlund: Yeah, we don't know what they are going to be.

Benz: Right.

Fahlund: We have no idea what taxes are coming down the pike, except the ones next year and maybe in 2013. So that's a way that will give you flexibility and control, a lot more control over your assets than if all of your money, for example, is in your 401(k) plan or a rollover IRA, where at 70 1/2, that moneys has to start coming out.

And you're not going to be able to dictate how much you take out. The minimum amount will be dictated by the government and on top of that, the amount you'll have to pay in taxes on that will be dictated. So getting the flexibility and control really comes with moving some of that money or contributing to Roth 401(k) accounts or to Roth IRAs.

Benz: Right. And you've been an advocate also of taking a look at whether that conversion makes sense for people at this time.

Fahlund: Absolutely. For some people, it doesn't. If you are very close to retirement and you have limited resources, spending money to pay taxes in advance probably doesn't make any sense. But for other investors, they really have money here that they don't even need and they are probably not going to tap. So for them to convert it, some of it at least, to a Roth IRA makes a lot of sense, because then they can grow that money and maybe use it as a cushion late in retirement if they need long-term care, extra medical expenses. And if they never use it, hallelujah, it can go to the children and grandchildren.

Benz: They don't have to deal with those required minimum distributions.

Fahlund: They don't. And the children and grandchildren will receive, if they put the money in an inherited Roth IRA, will receive tax-free income for years and years.

Benz: So, let's talk about a related question often called asset location. What goes where? So say, I've got my Roth assets and maybe some taxable assets as well as some assets that I will pay taxes on upon retirement, how do I think about putting assets in these various pools of money?

Fahlund: Well, I think this a very interesting question because, first of all, you need to start with what is your asset allocation and get that right, so that you're properly diversified, you know what their overall portfolio, across all of those account registrations, is going to look like. Then you start digging into it and deciding where you're going to put everything.

And what we have discovered in our research at T. Rowe Price is that intuitively, you want to put your bonds in the tax-deferred account. And one of the reasons we've always given in the past in the industry is, well, they are generating income that's going to be taxed at ordinary income tax rates. So it's a great asset to put in that account.

And then you could put your stocks where you may have more capital gains in the taxable account. And our research shows that that's absolutely true. It was validated. But we found that one of the reasons for doing it had been overlooked. And that is, that when you have your assets in the tax deferred account, as we mentioned, if it's not a Roth, then you start having required minimum distributions at 70 1/2.

Well, if you had put your stocks in there instead, they have more growth opportunity, more growth potential, presumably, and you would have been growing your RMDs, growing that account so that the government takes the taxes and you get the rest.

Why do that? Why not, if you have bonds in your portfolio anyway as part of your allocation, why not put the bonds in there? They may be slower growers, you get – you're not forced to take out as much because the balance in your account is lower. And put the stocks, as we were saying, in the taxable account and in the Roth account. And that way you maximize the growth of the stocks and you minimize the growth of the amounts you are required to take out.

Benz: Well, thank you, Chris. Those were some helpful insights. We appreciate you taking the time to be here.

Fahlund: It's a pleasure.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.