September 11, 2023

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Tax diversification: What is it, and why it is so important

Your retirement could last several decades, so it is important to minimize the impact of taxes on your savings. One way to protect your savings is by spreading out your investments across various types of investment accounts using a strategy called tax diversification.

What is tax diversification?

Tax diversification makes use of a variety of investment accounts with different tax treatments. Because different types of investment accounts offer specific tax advantages, you can gain more control over your taxes by placing your investments in various types of accounts.

How tax diversification works

There is not a one-size-fits-all approach for tax diversification, but it is a way to view your investment accounts through the lens of three tax attributes — tax-free, tax-deferred, and taxable — and then decide how to strategically allocate your assets among them. The idea is to diversify your retirement funds among different account types during your working years as you save for retirement.

What are the key benefits of tax diversification?

In general, many investors gravitate toward tax-deferred accounts — such as a 401(k) plan — and thus, tend to be overweighted in investments that will be taxed in retirement. By diversifying your investments across all tax treatments, you can:

• Take more control of your financial picture, now and in retirement. Taxable and tax-free accounts do not have distribution requirements, which allows you to control when and how much of a distribution you take. Tax-deferred qualified accounts like IRA’s and 401k’s generally require distributions at age 73 (depending on the year you were born), but you control both distributions from tax-deferred accounts before age 73 and the amounts you take over the required minimum distribution (RMD).

• Potential savings over time will help your assets last longer. Being able to withdraw funds from different types of accounts during retirement could allow you to spread your taxable distributions over more years, so you pay less in taxes and keep more of your savings.

Example of Tax Diversification:

You decide to make contributions to a Roth IRA or Roth 401k early in your career. There is no tax deduction for the contribution, but since your marginal tax rate is usually lower earlier in your career, the value of the tax deduction is worth less. It makes sense to contribute most of your savings early in your career to a ROTH as these funds will be tax-free in retirement.

As you get older, you start contributing to a traditional IRA or 401k (tax deferred). You get a tax deduction for your contribution and more value for that deduction as you are in a higher marginal tax bracket. You will have to pay taxes later when funds are withdrawn (note in addition to paying taxes on the withdrawal, there is a 10% penalty if you withdraw funds before age 59 ½).

As you get into your prime earning years, ideally you still have additional funds to save (after maxing out retirement plan contributions) in a taxable account investment account. You will pay taxes on any dividends and capital gains each year, but at lower tax rates. Any withdrawals later in retirement will only be taxable to the extent that there is a gain on the distribution.

If done correctly as stated above, you will have options when you retire as to which accounts (tax-free, tax deferred, taxable) to draw from which will allow you to manage your taxable income and thereby manage your marginal tax rate.

Note – Once you have children, you may also choose to contribute to a 529 plan as these funds will also be tax-free as long as they are inevitably used for post-secondary educational purposes.

When should an investor consider tax diversification?

Some opportunities may exist to diversify your tax situation during retirement, but in many cases tax diversification should be done over time. The sooner you consider how and when your retirement assets are taxed, the more time you must make adjustments and accrue any potential benefits. 

As always, it is best to consult a tax or investment professional before making these important decisions. 

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Important Disclosures:

Securities offered through IFP Securities, LLC, dba Independent Financial Partners (IFP), member FINRA/SIPC. Investment advice offered through IFP Advisors, LLC, dba Independent Financial Partners (IFP), a Registered Investment Advisor. IFP and Finspire, LLC are not affiliated.

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