You’re certainly aware of the importance of diversification when it comes to your portfolio, but have you considered how being diversified from a tax perspective influences your retirement plans?
What is tax diversification?
This is an approach to investing that involves allocating your assets across investments that have different tax treatments. This isn’t to be confused with asset allocation, of course, which refers to spreading your investment dollars among varying asset classes in order to appropriately balance risk and reward.
However, tax diversification does help you balance risk and reward, in that you’re investing to mitigate the risk of unnecessary tax exposure and to maximize after-tax growth of your retirement accounts.
Tax-deferred vs. tax-free vs. taxable
There are essentially three types of investment accounts when it comes to taxation: tax-deferred, tax-free and taxable.
- With a tax-deferred account (such as a 401(k) or 403(b) or a traditional IRA), you receive a tax deduction at the time you make a contribution. Those contributions grow tax-free until you withdraw funds, at which time you’re taxed at ordinary income rates.
- Tax-free accounts are those that you fund with after-tax contributions, where your money grows tax free and distributions are generally tax-free (subject to certain conditions). A Roth IRA, Roth 401(k), 529 plan, and municipal bonds all fall in the tax-free category.
- A taxable account is one where you’re taxed on dividends you receive during the year, or on capital gains. Examples include Individual, joint and trust brokerage accounts, just to name a few.
A tax-diversification strategy
Taxes are inevitable, but you don’t want taxes to eat into your retirement savings more than necessary. Tax planning strategies are an important part of your financial planning, and are best implemented earlier rather than later—even decades prior to retirement, if possible.
Your best strategy for being tax-diversified will depend on a number of factors, including your tax bracket, where you live, and how old you are. Your wealth advisor and tax professional should work together and with you to achieve three objectives:
#1 You have as much control as possible over the tax piece of your financial picture.
While no one can predict what tax rates will be decades into the future, you can work with your tax advisor and wealth manager to see how long your savings might last under different potential tax scenarios—including different tax brackets. This can help guide your investing decisions.
#2 You invest with a goal of reducing your lifetime tax burden.
There are certain tactics you can use to ensure you’re not paying more tax than you need to. For example, when you convert savings from a traditional IRA to a Roth IRA, you pay taxes on the amount you convert. For this reason, it can sometimes be beneficial to convert earlier (when your IRA nut is smaller) than later to a Roth, where your money can grow tax-free.
Taking distributions before required minimum distributions (RMDs) kick in (age 72 if you were born after July 1, 1949; age 70 ½ if born before that date) can spread your tax bill out and sometimes limit how much you pay, particularly if you are in a lower tax bracket than you may be later.
#3 You have a flexible and sustainable plan for withdrawing funds that keeps taxes in mind.
That’s right: It’s not just about where you put your money that has an impact on your overall taxes paid. It’s also about when and how you withdraw funds from different types of accounts. If, for example, you can leave your 401(k) and traditional IRA funds untouched early in retirement, a larger chunk of that money can continue to grow tax free.
Do you wonder what your long-term tax picture looks like? We can help you implement tax-efficient strategies into your investment and wealth planning. Reach out to get started today.