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What assets should be placed in which retirement accounts

In my previous post I discussed about how I would prioritize my retirement savings.  I suggested it would be prudent to invest in retirement accounts over time, with the goal of creating tax diversity. That is, by having funds in tax deferred, tax free, and taxable accounts.  In this post I’ll discuss what type of assets should be purchased in these different retirement accounts.

Each person’s situation is different. What assets you purchase in each retirement account depends on several reasons, but the biggest factors are: the number of years you are from retirement, how much funds you have in each type retirement account, and your financial goals. For example, the following is an outline of what I have done and why I made the choices.

First, let me say that our goal is to spend all of our assets in retirement. We do not have any direct heirs to pass assets on to and, if any assets are remaining upon my spouse and my death, some assets will go to charity and some will go to other family members. If we did have a goal of leaving some assets to heirs, I would probably set up a separate account funded by the amount we wished to leave to our heirs and managed this account assuming a longer investment timeline. However, I would maintain control of this account in the event that we needed the funds for any reason later in life.

When deciding what assets to purchase in which accounts, the main goal is minimizing the tax bite. Therefore, the first step is to determine how much assets one has in each type of account. In our case, we have about 35% of our total financial assets in traditional tax-deferred retirement accounts, 25% in tax-free retirement accounts (i.e., Roth accounts), and about 40% in non-retirement accounts (i.e., taxable accounts).

In setting up my retirement income withdrawals I generally follow the Buckets Strategy which I discussed in a previous post. This strategy calls for placing your guaranteed income assets in your first bucket to be withdrawn in the early retirement years and positioning your riskier assets to be withdrawn in your later years.

My first bucket is my 10-year fixed income ladder that I set up a few years before I retired. My Safe Withdrawal Rate (SWR) is 4%. A 4% SWR for 10 years equals about 40% of our retirement assets. This 10 year fixed income ladder is located 50% in our taxable accounts and 50% in our tax-deferred accounts.

The reason I split our income ladder between the two accounts is I wanted the ability to withdraw some tax-deferred retirement assets before the mandatory withdrawals are required at age 701/2. I may withdraw some of these assets earlier than age 701/2 so I can fill up the 15% tax bracket and lower my mandatory minimum withdrawals that begin at age 701/2. This is an important tax move because at age 70 I will begin receiving social security benefits. Social security income combined with mandatory minimum withdrawals from tax-deferred accounts can push us into a higher tax bracket. So I want to minimize this possibility by drawing down some tax-deferred assets before age 701/2. I would do this in years when it makes sense to do so depending on other taxable income.

My second bucket is about 35% of our total assets. This bucket contains large-cap high quality dividend paying stocks. After our fixed income ladder is exhausted in 10 years, these funds should grow in real dollars to fund about 10 more years of retirement. These high quality stocks are located partly in our taxable accounts and partly in our tax-deferred accounts.

The balance of our taxable accounts that is not part of our fixed income ladder, about 20% of our total assets, I have purchased individual stocks. The only time I would recommend anyone purchase individual stocks is if they have a significant amount of assets outside tax-sheltered retirement accounts. There are two reasons for this. First, stocks currently receive preferential tax treatment; second, with mutual funds you cannot control the annual capital gains distributions. This reality makes it more difficult to control your annual tax bill. When I buy individual stocks, I only purchase high quality dividend paying stocks such as Pepsi, Intel, Johnson & Johnson, Home Depot, Walmart, etc.

The balance of our second bucket, about 15% of our total assets, is located in our tax-deferred retirement accounts.

Our third bucket is 25% of our total assets. Our third bucket contains our riskiest assets which should over the long term provide the highest return. These assets are emerging market stocks and US small cap stocks. After our first 2 buckets are exhausted in 20 years, I will start withdrawing retirement income from our third bucket. I project in 20 years this higher returning bucket will grow in real dollars to fund another 10 to 12 years of retirement. Our Roth accounts are about 25% of our total assets. Therefore all of our emerging market and small cap mutual funds are in our Roth accounts.

The table below summarizes what assets are in which accounts:

This income withdrawal approach is designed to provide income for 30 years. However I have not included any social security income in this retirement income plan. Whatever we get from social security should allow us to withdraw less from our retirement accounts extending their life beyond 30 years.

One thing worth noting is that I do keep about 20% of the funds in my second and third buckets in cash or cash equivalents. I do this in order to have some cash available for any re-balancing moves that may be necessary in each of these tax-sheltered accounts. This means that my overall asset allocation is about 52% fixed income and 48% equities. Also I should note my gold allocation is sprinkled in all three type retirement accounts.

So, in general, my advice is if you are close to retirement, place your low or zero risk assets in the retirement accounts you will withdraw from first and your more risky assets in your retirement accounts you will withdraw from later. For most people this sequence of withdrawals will be, first — taxable accounts, second — tax-deferred accounts, and third — tax-free accounts (i.e., Roth accounts).

If the dollar amount of each type account is not the right size for the type asset you would like to purchase, you should purchase assets in each account as close as possible to your desired amount. The balance should be purchased in the next type retirement account to be withdrawn from.

Finally, for those planning on retiring before you can make penalty-free retirement account withdrawals (i.e., before age 591/2), it is important to build up assets outside of your tax-sheltered retirement accounts. Also having a larger taxable account allows you to delay withdrawals from those that are tax-sheltered. The longer you can wait to withdraw funds from your tax-sheltered retirement accounts, the larger they will grow tax free.

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