What is Tax Diversification?
Tax diversification is a strategy considering various tax treatments across the investment accounts you will eventually use for retirement income. Because different types of accounts and investments provide different tax benefits, you can gain more control over your taxes by diversifying your investments.
When combined with a tax-efficient withdrawal strategy, tax diversification may help your assets last longer in retirement. When making investment decisions, taxation is only one factor to consider.
Taxable and tax-deferred accounts are the two basic types of investment accounts. When you invest in taxable accounts, such as a regular brokerage account, your money is neither tax-deductible nor grows tax-deferred. Instead, the investor is taxed on any dividends received during the year and capital gains—if and when an investment is sold at a price greater than the price at which it was purchased. Tax-deferred accounts, such as IRAs and 401(k)s, allow money to grow tax-free until it is withdrawn.
During your working years, you should diversify your retirement funds among different account types as you save for retirement. There are two ways to accomplish this: You can diversify while saving and move investments in and out of the various types of accounts after you’ve saved into them. Moving investments in and out of a taxable account, on the other hand, can have tax consequences, whereas moving investments in retirement accounts, such as traditional or Roth IRAs, usually does not.
1. Benefits of Tax Diversification
Take charge of your financial situation now and in retirement. Other than the Roth 401(k), taxable and tax-free accounts have no distribution requirements, allowing you to choose when and how much to withdraw. Distributions from qualified tax-deferred accounts are generally required at age 739, but you have control over distributions from tax-deferred accounts before age 73 and amounts you take over the RMD.
Potentially save money on fuel and help your assets last longer. The ability to choose which assets are used to generate your income may allow you to spread your taxable distributions over a longer period, allowing you to pay less in taxes and keep more of your savings.
Gain future flexibility in how you access retirement income. Life events are likely to alter your future savings and income requirements. Diversifying your savings across these various tax treatments will provide you with greater flexibility as expected and unexpected life events occur.
2. How Does Tax Diversification Work?
Tax diversification, like other investment diversification principles, allows you to reduce risk and position yourself to be more profitable in the long run. Tax diversification has three major advantages.
The first step is to lower your total tax bill. For example, in early retirement, you can withdraw from tax-deferred accounts to lower your tax bracket and lower the taxes you pay over the account’s life.Diversified accounts enable you to make long-term tax-saving decisions.
The second advantage is that you will not be hit with a large tax bill all at once. If you save in both a Roth IRA and a 401(k), you pay taxes on the first and pay taxes on the second when you withdraw. This saves you money in retirement, when a dollar may be worth more.
The final advantage is flexibility. If you have unexpected retirement expenses, not having to withdraw a large sum from a tax-advantaged account that will push you into a higher tax bracket could be a lifesaver.
3. Difference Between 401(k), Roth IRA, and Traditional IRA
In savvy personal finance, a general rule of thumb is to consistently contribute enough to a 401(k) to be eligible for the full employer match If you can save more money for retirement, put it in a Roth IRA.
Usually, the best way when deciding between traditional (pre-tax) and Roth (after-tax) contributions is to use a traditional IRA or traditional 401(k) if you anticipate retiring in a lower tax bracket.Use a Roth IRA if you expect to be in a higher tax bracket during retirement. Traditional and Roth have equal benefits if you are in the same tax bracket during retirement as you were when you made the contributions.
Because of taxation, it may be prudent to maintain a regular brokerage account in addition to your retirement accounts. All qualified retirement accounts grow tax-free, with withdrawals taxed as ordinary income. Withdrawals from taxable accounts, on the other hand (from the sale of securities such as stocks or mutual funds), are taxed at capital gains rates. Roth IRAs are unique because contributions are made after tax, and qualified withdrawals are tax-free.
You put in a lot of effort to save for retirement. The sooner you think about how and when your retirement assets will be taxed, the more time you will have to reap the benefits. Because there is no one-size-fits-all approach to tax diversification, your financial advisor will make personalized recommendations based on your financial goals, time horizon, and tax situation in collaboration with your tax advisor.