Is Your Retirement Portfolio Ready to Do the 'Twist'?

The conventional rules of thumb on asset location--which assets to put in your taxable accounts and which to hold in tax-sheltered vehicles--are pretty straightforward and intuitive. Because bond income is taxed at your ordinary income tax rate, it's the most onerous from a tax standpoint. Thus, you'd generally want to park the bulk of your fixed-income assets in your tax-sheltered accounts because you won't owe taxes on those assets on a year-to-year basis. Meanwhile, equities, especially non-dividend-payers, tend to be more tax-efficient so are therefore a good fit for taxable accounts.

But there's a problem, especially for those nearing or in retirement: The rules about sequencing in-retirement withdrawals--deciding which assets to draw from which account types and when to do it--are at odds with the standard asset-location rules. As I outlined in this article, retirees will generally want to start by liquidating those assets that are most costly from a tax standpoint on a year-to-year basis--starting with required minimum distributions, moving to taxable accounts, and then segueing to traditional IRAs and 401(k)s. Roth assets, which have the longest-lasting tax-saving attributes and are also the most advantageous when left to heirs, should be tapped last.

That framework for sequencing withdrawals would call for keeping the most liquid assets--bonds and cash--in taxable accounts because they'll be among the first to be tapped in retirement, while moving long-term assets such as stocks into traditional IRAs, 401(k)s, and Roths.

By now, you may have spotted the problems. In essence, the optimal in-retirement asset-location framework is the exact opposite of the ideal asset-location framework for accumulators. The upshot? At some point, pre-retirees may need to "twist" their portfolios, relocating at least some bonds in their taxable accounts for liquidity purposes while moving equity assets to tax-sheltered wrappers. It's also worth noting that the optimal asset location for retirement withdrawals will tend to be less tax-efficient than is the case for accumulators, so tax-savvy retirees will need to keep an eye on limiting the tax collector's cut as they adjust their portfolios and manage them on an ongoing basis.

Needless to say, optimizing a portfolio for in-retirement distributions is complicated stuff, and it's also highly dependent on an individual's own circumstances, including the level of wealth, tax brackets (which may change from year to year), and the ratio of tax-sheltered to taxable assets. For this reason, many individuals might find that obtaining customized retirement-distribution guidance from a financial or tax advisor will be money well-spent.

Although one article can't begin to do justice to this complex topic, here are some of the key steps to take as you determine whether--and how much--you may have to twist your portfolio in the years leading up to retirement as well as how to do it in the most tax-efficient manner possible.

1) Evaluate what changes are in order.
If you've been maintaining a conservative asset mix in your taxable portfolio all along, your portfolio isn't likely to need a major realignment as retirement approaches. Ditto if the bulk of your portfolio is in tax-sheltered accounts and you expect to receive most of your retirement income from some combination of 401(k)/IRA distributions, a pension, and Social Security; in that case, your tax-sheltered portfolio can be well-balanced among asset classes. 

But if your retirement portfolio includes both tax-sheltered and taxable assets and you've been following the conventional rules of thumb about asset allocation, adjusting which assets you hold in which accounts will be more important. This article walks through the steps to take when formulating your retirement distribution plan--how much you'll need and which assets to tap first. If you're using the bucket approach to staging your retirement portfolio, you can then back into appropriate asset allocations for your taxable and tax-sheltered assets based on when you'll tap each pool. Ideally, you'd map out where your in-retirement income is coming from on a year-by-year basis (or in five-year increments). That exercise, in turn, can help you see where you need to make changes to the asset allocations of your taxable and tax-sheltered portfolios: The shorter the time horizon, the more conservative the composition of that pool of money should be.

For example, a new retiree who expects to tap most of his taxable portfolio within the first 10 years of his retirement will need to shift at least some of that portfolio into cash and bonds; otherwise, his distributions are apt to be buffeted around by market winds. Don't forget to factor required minimum distributions into the analysis; once those kick in, you might be relying less on your taxable portfolio for income than you did earlier. Thus, you may need to make fewer asset-allocation adjustments than it might first appear.

2) Determine the tax implications of repositioning.
Even though the goal of these adjustments is to take maximum advantage of tax-sheltered accounts for as long as possible, the twist itself can cause tax complications if it involves selling assets from your taxable accounts.

Of course, there are no tax consequences to changing up your tax-sheltered portfolios to make them more equity-heavy; the beauty of these accounts is that you can tweak them all day long without incurring any tax costs when selling appreciated assets. Thus, you can readily reduce your bond holdings while boosting your equity positions in those accounts. Repositioning your taxable accounts, meanwhile, can be more problematic from a tax standpoint, particularly because you might be reducing your percentage in stocks and stock funds, in which you could have embedded capital gains.

Start by determining your cost basis in the securities you'd like to lighten up on and comparing it to the current share price. If you have sizable capital gains built up in your holdings, you can reduce the tax hit in any one year by scaling back your taxable portfolio's equity stake over a period of years rather than doing so all in one go. After all, you won't likely be tapping your taxable portfolio all in one year, so you can afford to give it a more conservative cast over a period of time. Alternatively, you can be more tactical about reducing your equity weighting, selling appreciated securities in years when you have offsetting losses or are otherwise in a lower tax bracket.

3) Assess whether municipal bonds merit a greater role.
Because taxable assets are among the first in the queue when it comes to taking distributions, that means the taxable component of many retiree portfolios will likely include a larger share of bonds and cash than it did during the accumulation phase. To help reduce the drag of taxes on this portion of the portfolio, retirees and pre-retirees who have heretofore stayed away from municipal bonds might consider them; the tax-equivalent yield function of Morningstar's Bond Calculator can help gauge whether skirting federal and in some cases state tax helps make up for the typically lower yields attached to munis. At the same time, it's a mistake to populate your taxable portfolio with muni bonds exclusively, as I argued in this article, because the asset class doesn't give you the same ability to diversify that you can obtain by holding both muni and taxable bonds.

4) Build in flexibility and balance.
Although the rules on sequencing withdrawals can help you figure out which assets to put where, it's a mistake to hold all of one asset class in any specific investment wrapper. That's because in any given year of your retirement, you'd want to reserve the right to be opportunistic about from where you draw the assets. For example, you might want to draw assets from your IRAs and 401(k)s in years when you expect to be in a lower tax bracket (and therefore the tax hit would be less), in which case you'd want to maintain at least some bonds there. And, as previously discussed, when you have to begin taking RMDs from IRA and 401(k) assets, you'll want to draw it from more liquid pools of capital; that's another reason to hold some bonds and cash in those accounts. By the same token, you might want to keep some stocks in your taxable account to take advantage of tax-loss harvesting opportunities.

A version of this article appeared Sept. 13, 2012.

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