Your Portfolio Is Most Likely Tax-Inefficient and Your Statement Won't Tell You
Most people don't realize that a future tax bomb may be building inside each of the investment accounts that make up their overall portfolio. Leaving Roth accounts aside for a moment, pre-tax retirement accounts and taxable investment accounts are structured differently, but each can create a real tax drag if it isn't set up properly.
Take someone who is retiring with a $2 million pre-tax retirement account. That account isn't truly worth $2 million, because 100% of every withdrawal is taxable. If they're in the 22% marginal tax bracket, nearly every dollar that comes out takes a 22% federal haircut, plus any state income tax that applies.
Yes, depending on income levels and the size of the withdrawal, some of it may fall into lower brackets or not be taxed at all. But most people rely on this portfolio to produce their income, so for them, the tax bill is very real.
Taxable investment accounts work differently. When a position is sold at a gain after being held for more than a year, it's taxed at long-term capital gains rates, which is 15% for most people, plus any state tax that applies. That's usually more favorable than a pre-tax withdrawal. What often gets missed, though, is that these accounts usually aren't set up to be tax-efficient in the years before anything is sold.
The surprise tax bill hiding in taxable accounts
We constantly see new clients arrive with taxable accounts that throw off significant dividends and mutual fund capital gains distributions every year, without a single position being sold. That's the "cost of doing business" when you hold large amounts of tax-inefficient investments in this type of account.
Last year alone, I met with about five prospective clients who had been hit with surprise capital gains distributions from mutual funds they owned, each in the range of $50,000 to $100,000. In every case, it meant a higher tax bill than they had planned for. For one of them, the extra income caused them to pay back the entire premium subsidy they had received through the ACA Health Insurance Marketplace.
In another case, the client's advisor decided they "needed" to liquidate a position, which created a $180,000 long-term capital gain. The client didn't find out until they filed their taxes. That advisor had never asked for a copy of the client's tax return, yet was making decisions with a major tax impact.
This is a long way of saying that your portfolio is most likely tax-inefficient, your statement won't tell you that, and in a lot of unfortunate cases, your advisor won't either.
Why asset location matters so much
This is exactly why asset location is so important. Asset location simply means deciding which investments belong in your taxable, tax-deferred, and Roth accounts. It's also why two portfolios with identical holdings can end up with very different after-tax results.
Good planning goes a step further. It looks for opportunities to sell those "problem" mutual funds in lower-income years, when you may pay very little in capital gains tax, and sometimes 0%. That clears a path to a more tax-efficient portfolio going forward. It can also open the door to accelerating IRA distributions or completing Roth conversions, which helps defuse the tax bomb before RMD age and can reduce your lifetime tax bill. On the other hand, proactive planning may be able to help you AVOID paying more taxes by not completing Roth conversions – every situation is different, there is no blanket answer. Do not let any one tell you differently – cookie cutter is never good.
For people who still have more runway before retirement, I often find they benefit from a balance of pre-tax and Roth contributions. That mix creates flexibility later. You can take larger pre-tax distributions in lower-income years, ideally paying less tax than you saved when you contributed. Then you can draw from Roth accounts in higher-income years, once RMDs kick in, or when a big purchase comes up.
This is where asset location adds another layer of flexibility. It's about owning certain assets in specific account types based on each account's tax treatment, and also on each asset's growth potential:
- Roth accounts: Your highest growth potential assets, since that growth can come out tax-free.
- Pre-tax accounts: Your lowest growth potential assets, since every dollar withdrawn is 100% taxable.
- Taxable brokerage accounts: Your most tax-efficient assets, such as ETFs, individual stocks, and low-dividend securities.
As I mentioned earlier, one very important thing to watch in taxable accounts is the ongoing tax from dividends and mutual fund distributions. In the short term, this is where a lot of extra, surprise taxation happens when the account isn't structured properly for its tax treatment.
Why this matters in the short and long term
Once you start taking withdrawals in retirement, you need a plan of attack for which account to tap first, or which combination.
Say a client is 60 years old and their Required Minimum Distribution (RMD) age is 75. We need to be strategic about where their income comes from so they stay in the lowest tax bracket possible. They got a tax break on their pre-tax contributions during their working years, but by RMD age, those required withdrawals could push them into the 24% bracket.
In simple terms, waiting until RMD age to touch pre-tax accounts can create a tax bomb that goes off down the road. On the other hand, their retirement lifestyle may let them withdraw just enough pre-tax money each year to stay in the 12% bracket. That shrinks what they're forced to take at RMD age and means they may be withdrawing at a lower rate than they saved when they contributed.
The goal is to draw down a meaningful amount of pre-tax assets in the years before RMDs begin, filling in the gaps with Roth, taxable, and cash as needed. This ties right back to asset location. Because the Roth and taxable accounts hold the more growth-oriented investments, the client can let those accounts keep growing while pulling income from the more conservative bond holdings in their pre-tax accounts.
Where this meets your estate plan
This also connects directly to your estate plan, because each account type is treated differently when it's inherited. (I cover this in more detail in my previous article on estate planning.)
Pre-tax accounts. When a non-spouse inherits a pre-tax account, they generally must empty the entire balance by the end of the 10th year and pay income tax on every dollar. That can mean huge tax implications for your beneficiaries, especially if they're in their peak earning years. Under more recent IRS guidance, if the original owner had already started taking RMDs, the beneficiary must also take annual distributions during those 10 years. If the owner hadn't started RMDs, the account simply needs to be empty by the end of year 10.
Roth accounts. The 10-year rule still applies to inherited Roth accounts. But because Roth money has already been taxed, withdrawals are generally tax-free, which is great news for the people inheriting them.
Taxable accounts. Much like Roth, inheriting a taxable investment account can be a real advantage for a non-spouse beneficiary, from both a tax and a flexibility standpoint.
Here's why. Let's say Mom and Dad bought XYZ stock back in 2005 for $10,000, which becomes their cost basis. Over time, the position grows to $150,000. If they sold it themselves, they would owe capital gains tax on the $140,000 gain. At a 15% capital gains rate, that's $21,000 in federal tax.
Now suppose that in 2026, before selling, Mom and Dad pass away, and the $150,000 position passes to you as the sole beneficiary through a transfer on death (TOD) registration. Under current tax law, you receive a step-up in cost basis to the value on the date of death. Instead of $10,000, your cost basis is now $150,000, and any future gain is treated as long-term.
That means you could sell the entire $150,000 position shortly after inheriting it and pay $0 in capital gains tax. Again, $0. Not a bad deal, and thanks to the TOD registration, the account passes outside of probate.
Compare that to inheriting a pre-tax account, where you're required to withdraw the full balance within 10 years and pay ordinary income tax on all of it, likely during your highest-earning years.
That's why, when it makes sense from a tax and retirement planning perspective, I'll actually encourage people to withdraw more from their pre-tax accounts than they need. Those extra dollars can go into a Roth account through a Roth conversion, or into a taxable investment account.
The end result is that the client pays less tax on their pre-tax withdrawals than they saved when they contributed, and their non-spouse beneficiaries inherit Roth dollars they can withdraw tax-free and taxable assets that receive a step-up in basis.
The bottom line
Your investment statement shows you what you own and what it's worth. It doesn't show you what you'll actually keep. The difference between those two numbers is decided by which accounts hold which investments, when and how you withdraw, and how your assets pass to the people you love.
That's why investment decisions and tax decisions can't be made in separate rooms. An advisor who has never looked at your tax return is making decisions with one eye closed.
When your investments, your tax return, and your estate plan are coordinated, small changes each year can add up to hundreds of thousands of dollars saved over a lifetime, for you and for the next generation.
This level of planning does take more work and a solid understanding of the tax code. But for most families with significant assets, it's among the most valuable planning they can do, and it's far easier to act today than after the tax bomb has already gone off.
If you have any questions – please reach out!
Happy planning.