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 think of tax diversification. It’s the same idea, except that instead of investments, it’s about strategically spreading your tax risk—because tax rates can change unexpectedly over time.
When you oneRe-taxation varies depending on the type of investment
Tax diversification focuses on when you will be taxed on your investments. Because different types of investments vary depending on when taxes come in, you have some flexibility to spread your tax risk over a lifetime. After all, the difference between the 10% and 37% tax rates is considerable when it comes to hundreds of thousands of dollars.
As Kiplinger explains, here are the three basic categories of investments, depending on when they are taxed:
- Always taxed: Assets for which you are required to pay income taxes each year, such as investment brokerage accounts (or even checking accounts), which may earn interest, dividends, realized capital gains, and / or distributions of capital gains.
- Taxed later (deferred): Assets for which you only have to pay tax at the time of withdrawal / distribution, such as a 401 (k) or 403 (b), or when a capital gain is realized, such as many forms of property real estate or other durable goods.
- Rarely taxed: Assets for which you are rarely, if ever, required to pay income taxes, such as a Roth IRA, interest on municipal bonds, and certain types of specially designed life insurance.
How tax diversification works
To illustrate how tax diversification works, imagine putting all of your money in a 401 (k) account, which is a “tax later” investment account. Most people do this on the assumption that they will be in a lower tax bracket later in retirement, but that is not necessarily the case. As Kiplinger points out, every dollar withdrawn from a 401 (k) is considered regular income, as if it came from your monthly salary while you were still working. As a result, you may still pay the same tax rate in retirement as you do today (your lifestyle won’t necessarily be cheaper in retirement, as is commonly assumed).
Moreover, with 401 (k) s we are talking about decades of deferred taxes. There is no way to know if your income bracket will be change in the future due to changes in tax policy. You cannot automatically assume your tax rate will stay the same.
TThis is where fiscal diversification comes in. Using the same example, you can spread your tax burden by dividing your investments between a 401 (k) and a Roth IRA, which is a “rarely tax” investment account (although you want to maximize your 401 (k) contributions. compensation from the employer first, if you can).
Roth IRAs are “rarely tax” (or “after tax”) in the sense that you pay income taxes. before you actually deposit it into your Roth account and withdrawals are tax free (after age 59.5). All that’s left is yours to grow tax-sheltered for as long as you have the account (there are, however, contribution limits and income-based restrictions).
In this way, a Roth IRA is basically the opposite of a 401 (k) in the way it is taxed. By having both types of accounts, however, you would have more flexibility to mix up your withdrawals later based on tax bracket considerations. For example, maybe a smaller required distribution of a 401 (k) plus a non-taxable Roth IRA withdrawal could keep you in a lower tax bracket compared to relying solely on the 401 (k). .
At the end of the line
Since tax diversification depends on many factors like your age, income, lifestyle, and retirement plans, you should consult a financial advisor to help you navigate all of your investment options. Life events can easily change your priorities too, so it’s best to think of tax diversification as an ongoing conversation about what’s best for you rather than a fixed plan.