What is asset location?

For years, Americans were told that diversifying their assets could help them manage the ups and downs of the market, smooth out their returns and protect against risk. However, while asset allocation — allocating money across a variety of asset classes — is important, retirees may need more than the typical 60/40 portfolio of stocks and bonds to accumulate the assets they want and generate the income they need in retirement.

Many financial professionals are now including different kinds of investments in their clients’ portfolios to diversify beyond equities and fixed income investments. These may include alternative investments, structured products or derivatives to offset equity risk and may be looking to replace bonds when interest rates are low. An asset location strategy with insurance — annuities in particular — may be another option.

Unlike asset allocation, which focuses on the types of assets in a portfolio, an asset location strategy considers the tax consequences of an investment vehicle or whether it is taxable, tax deferred or tax free. The objective is to blend different asset locations so that when the investor takes income, it is more tax efficient than having substantial income taxed at the highest rates.

Why is asset location important?

As people retire, they withdraw income, drawing down the assets they accumulated in previous years. How those assets are taxed can make a big difference in how much retirees keep and are able to spend. Because we cannot control the amount of capital gains or income taxes we’re required to pay, we are left with the ability to control the location of our assets and how those locations are taxed. 

The chart below shows different sources of retirement income and how they are taxed. While some of these sources may be familiar to most Americans, others — like annuities — may not have been considered.

Sources of Retirement Income

* Under current Federal tax rules, loans taken will generally be free of current income tax as long as the policy remains in effect until the insured’s death, does not lapse or mature, and is not a modified endowment contract. This assumes the loan will eventually be satisfied from income tax-free death proceeds. Loans and withdrawals reduce the policy’s cash value and death benefit and increase the chance that the policy may lapse. If the policy lapses, matures, is surrendered or becomes a modified endowment, the loan balance at such time would generally be viewed as distributed and taxable under the general rules for distributions of policy cash values.

Tax benefits of annuities

In the past year, 66% of financial professionals have changed their approach to retirement planning. Of those who changed their approach moderately or a great deal, 46% are using annuities more for income purposes and 41% are using annuities more for asset growth and protection.²

There may be a number of reasons for this. But one reason is that annuities may help minimize taxes.

Like earnings within a 401(k) plan, earnings in an annuity are tax deferred until they are withdrawn, which is typically when the investor is retired and in a lower tax bracket. While some might argue that it is better to pay capital gains taxes on earnings now, instead of waiting to pay (higher) income taxes on earnings later – like you would using a managed money account -- there is no guarantee that capital gains tax rates will remain lower than income tax rates. In fact, some experts are predicting that capital gains tax rates will increase in the near future to help pay for government spending and the pandemic.

In addition, income through certain annuities may be part principal and part earnings, which makes the income more tax efficient, since only earnings are taxed. That’s assuming principal was invested post-tax.

A quick reminder about annuities

Because they are long-term financial products designed for retirement purposes, annuities aren’t for everyone. However, they may be an option for those looking for additional ways to grow, protect and generate retirement savings. In simplest terms, annuities are contractual agreements between an insurance company and an investor. Investors make one or more payments to the insurance company and the insurance company agrees to pay income or a lump sum back to them at a later date. There are some limitations as well as risk, fees and expenses, like many financial products.

Other benefits of annuities

Besides tax benefits, in both the accumulation and income phases of retirement, annuities also offer benefits that other types of investments might not provide.

No contribution limits

While some workers may have access to 401(k), 403(b) or 457 retirement plans, in which earnings are tax deferred, unlike annuities, those plans cap investors’ contributions. For high earners, those limits represent only a small portion of what they’ll need to save in order to continue to live the same lifestyle in retirement. Annuities, on the other hand, provide tax deferral without the contribution limits. 

Guaranteed asset growth

Tax rates are not the only uncertainty investors face. Market conditions are also a constant unknown, as returns fluctuate up and down based on the economic, market, and geopolitical conditions. Some annuities offer ways to guarantee asset growth, regardless of market conditions, and potentially protect or lock in that growth over time, setting them up to be an option for asset accumulation in retirement.

Protected lifetime income

Investors also face what’s known as longevity risk – the risk of outliving your money. That is why you may want to include protected lifetime income, or income payments that are constant and will continue for as long as you live, as part of your retirement plans. 

There are only three ways to get protected lifetime income payments: through the federal government via Social Security, private or public pension plans, or annuities purchased through an insurance company. 

Traditional pension plans are only available to a few workers these days, mostly in the public sector. Social Security may provide minimal income for many. But while not all annuities provide the same features and benefits, some are built to provide protected lifetime income payments, either through annuitization (turning assets into an irrevocable stream of income payments) or through certain optional benefits for an additional fee.

According to the Alliance for Lifetime Income, 3 out of 4 financial professionals believe that protection is important for their clients’ retirement income. But even more investors, 9 out of 10, believe the same to be true.² 

And, with a guaranteed stream of income in retirement, people feel more confident about their financial future. Of the 31% of Americans who have a source of protected lifetime income, such as a pension or annuity, in addition to Social Security, 65% expect their money to last their lifetime.³

Locating assets for protection as well as taxes

Just like you can benefit from an asset location strategy that includes income sources that are taxable, tax deferred and tax free, you may also benefit by locating your assets in investments that are not protected, partially protected and completely protected. In essence, you would be creating an asset location strategy for protection as well. 

The chart below shows different sources of retirement income and how much they are protected from market risk or the risk of outliving your income. As you can see, annuities can provide either partial or complete protection, depending on the type of annuity and the optional benefits selected. Besides Social Security and pensions, they are another way consumers can lock in guaranteed lifetime income payments.

Sources of Retirement Income

*Guaranteed payments are contingent on the ability of the payer to make good on promised payments.

Conclusion

With taxes a constant unknown, it may present an opportunity for investors to look at the locations of their investments for tax purposes, to minimize the amount they pay now and in retirement. But taxes aren’t the only uncertainty when planning for retirement. How long you’ll live and how the markets will react when you decide to take income should also play a role in your retirement plans, making asset location for protection another important option. Talk to your financial professional about asset location for taxes and protection today.

To learn more, visit our Perspectives page.