Why Tax Diversification Is a Smart Investment Strategy
Most people are familiar with portfolio diversification, which is a fancy way of saying “don’t put all your eggs in one basket,” but fewer people are thinking about tax diversification. This is the same idea, except that instead of investing, it is about strategically allocating tax risks, because tax rates can change unexpectedly over time.
When you are taxed depends on the type of investment
Tax diversification focuses on when you will be taxed on your investment. Since the different types of investments differ depending on when the taxes take effect, you have some flexibility to spread the tax risks over your life. After all, the difference between 10% and 37% tax rates is significant when it comes to hundreds of thousands of dollars.
As Kiplinger explains , there are three main categories of investments depending on when they are taxed:
- Always taxed: holdings that you have to pay annual income tax on, such as investment brokerage accounts (or even checking accounts) that can generate interest, dividends, realized capital gains and / or capital gains distribution.
- Taxable later (deferred): holdings in respect of which you are only required to pay taxes on withdrawal / distribution – for example, 401 (k) or 403 (b) – or when any capital gains are realized, for example, many forms of real estate or others solid assets.
- Rarely Taxed: Holdings that you rarely, if ever, are required to pay income tax, such as Rota’s IRA, municipal bond interest, and some specially designed life insurance.
How tax diversification works
To illustrate how tax diversification would work, imagine you deposit all your money in 401 (k), which is a “taxes later” investment account. Most people do this with the assumption that they will fall into a lower tax bracket upon retirement, but this is not always the case. As Kiplinger points out , every dollar withdrawn from 401 (k) counts as regular income – just as if it came from your monthly salary while you were still working. Therefore, it is possible that you may still be able to pay the same tax rate at retirement as you do now (your retirement lifestyle may not necessarily be cheaper as it is usually assumed).
Also, with 401 (k) s, we’re talking decades of tax deferred. It is impossible to know if your income level will change in the future due to tax policy changes. You cannot automatically assume that your tax rate will remain the same.
This is where tax diversification comes into play. Using the same example, you can spread your tax burden by dividing your investment between a 401 (k) and a Roth IRA, which is a “rarely taxed” investment account (although you will want to maximize your 401 (k) if you can, employer first agree on contributions).
Roth IRAs are “rarely taxed” (or “after tax”) in the sense that you pay taxes on income before actually depositing it into your Roth account and withdrawals are tax-free (after 59.5 years) … All that’s left is yours to grow tax-free as long as you have an account (however, there are contribution limits and restrictions based on income).
Thus, a Roth IRA is essentially the opposite of a 401 (k) in terms of taxation. However, with both account types, you have more flexibility to mix withdrawals later based on tax category considerations. For example, the possibly lower required distribution of 401 (k) plus a tax-free Roth IRA withdrawal could keep you in a lower tax bracket compared to relying solely on 401 (k).
Bottom line
Since tax diversification depends on many factors, such as your age, income, lifestyle and retirement plans, you should consult with a financial advisor to help you navigate all investment options. Life events can easily change your priorities, so it’s best to view tax diversification as an ongoing conversation about what’s best for you, rather than a fixed plan.