When it comes to retirement planning, not enough attention is paid to how much future taxes may reduce the ultimate value of retirement accounts. With billions of dollars held in tax-deferred retirement accounts like traditional IRAs, retirees will pay taxes at ordinary income rates, ultimately reducing the value of the assets drawn from those accounts.

Even less attention is paid to how taxes can potentially impact asset allocation. Because taxes will ultimately have to be paid from traditional IRA and 401(k) accounts, as well as taxable accounts with unrealized gains, those accounts actually have less long-term spending power than their balances might suggest.This means that unless those discounted values are taken into consideration when making asset allocation determinations, investors could be taking on either more or less risk than they are likely banking on.

How allocation can affect taxes
Here’s an example of a client with $10,000 in assets split between a tax-deferred account (e.g. a traditional IRA) and a pre-taxed account* (e.g. a Roth IRA) with a 60%/40% percent equity/fixed income asset allocation. The table below illustrates the potential impact of taxes on both accounts. Note how the asset allocation changes dramatically when considered on an after-tax basis.

Table 1 shows the allocations for this hypothetical client on both a pre-tax and after-tax basis. We have assumed a 30% Federal tax bracket and no state or local taxes for the traditional IRA.  

Table 1

Type of Account Pre Tax Allocation Allocation % After Tax Allocation Allocation %
Equity Tax-deferred (traditional IRA) $6,000 60% $4,200 51%
Fixed Income Pre-taxed (Roth IRA) $4,000 40% $4,000 49%
Total $10,000 100% $8,200 100%
The above example is a simplified one, as it doesn’t take into consideration the impact of all the taxes that may be relevant during an entire retirement. Nevertheless, it is valuable as an illustration of how far an asset allocation can get out of whack when the impact of taxes during the distribution phase isn’t taken into consideration.

Tax planning for the long haul
In order for investors and their clients better prepare for the impact of any tax liabilities on retirement savings, it may be more appropriate to think about asset allocation on an after-tax basis. This is especially true as clients move into retirement and the decumulation, or distribution, phase of the investment lifecycle. By applying asset allocation on an after-tax basis, both during the accumulation and distribution phases, advisors may be able to provide asset allocation models that are more accurately targeted to their clients’ risk profiles. With more accurate information in hand about the amount of funds likely to be available over the course of a retirement and improved data related to the expected returns of those assets, both advisors and their clients can make better decisions about saving and spending for retirement.

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Traditional IRA – An IRA or Individual Retirement Account allows individuals to direct pretax income, up to specific annual limits, toward investments that can grow tax-deferred (no capital gains or dividend income is taxed).

401K Plan is a type of qualified retirement plan in which employees make salary reduced, pre-tax contributions.

Roth IRA – A Roth Individual Retirement Account (ROTH IRA) is a retirement plan in which contributions are not tax deductible and qualified distributions are tax-free, provided the account has been open a minimum of five years

Natixis Global Asset Managment does not provide tax or legal advice. Please consult with a tax or legal professional prior to making any investment decisions.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.


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