Tax Diversification Basics
Diversification is a well-known strategy to manage investment risk, but how does it apply to taxes? Why would someone want to diversify their taxes, and how do you even do that?
Tax diversification is a powerful tool that can help you strategically manage your tax liability now and in retirement. The United States tax system is progressive, meaning tax rates increase with income. Your marginal tax rate is the rate you pay on your last dollar of income earned in a year. This is the rate we will focus on for this article.
To achieve tax diversification, you should spread your investments across three types of accounts, each with different tax treatments. Below, we have summarized the different types of account structures and their advantages and disadvantages.
Taxable Accounts
Brokerage and bank accounts funded with after-tax dollars. Accounts are subject to taxes on interest, dividends, and capital gains in the year they are realized. Qualified dividends and long-term capital gains are taxed at lower, more favorable rates. Upon death, beneficiaries receive a step-up in cost basis that matches the market value of the assets.
Pros:
- No income limits for contributions
- Flexibility in withdrawals without penalties
- Lower taxes for long-term gains and qualified dividends
Cons:
- Ongoing tax liability on earnings
- Less efficient for long-term growth due to taxes
Tax-Deferred Accounts
Qualified employer-sponsored retirement savings plans (401ks and 403bs) and individual retirement accounts (IRAs). They are funded with pre-tax dollars and will be taxed as ordinary income upon distribution. The IRS imposes required minimum distributions (RMDs) once account holders reach a certain age (varies by birthdate) based on life expectancy.
Pros:
- Immediate tax deduction on contributions
- Tax-deferred growth enhances compounding
Cons:
- Withdrawals are taxed as ordinary income
- Required minimum distributions (RMDs) begin at a certain age
Tax-Exempt Accounts
These accounts include Roth IRAs, Roth 401ks, and Roth 403b plans. They are funded with after-tax dollars, and qualified distributions are tax-free. Income limits apply to Roth IRA accounts; however, there are ways to convert non-deductible IRA contributions to a Roth account and bypass the limits.
Pros:
- Tax-free growth and withdrawals
- No RMDs (post Secure 2.0)
Cons:
- No immediate tax break on contributions
- Income limits may affect eligibility for Roth IRAs
Accumulating assets in different tax "buckets" allows you to tailor your withdrawal strategy to your tax situation each year. For example, in years where your taxable income is higher, you might draw more from tax-free accounts to avoid pushing yourself into a higher tax bracket.
Planning your contributions to different account types will largely depend on your expected income for the year. Ideally, you will make tax-exempt Roth contributions when your income is lower and tax-deferred contributions when your income is higher. It may also make sense to convert some of your pre-tax balances to Roth accounts in years with lower income to pay taxes at lower rates.
Monitoring your balances in tax-deferred accounts is crucial since RMDs will apply. A large balance can force someone to take higher distributions than they need, increasing their tax rates. If too much income is required, it could impact other rates, such as Medicare premiums and access to income-based programs. Ideally, you will save enough to generate the income you need in retirement without excess to manage your tax bracket and marginal rates.
The table below illustrates the impact of RMDs on different account balances, highlighting how large balances could increase income beyond one's needs.
Consideration should also be given to the expected tax rates for your beneficiaries who may receive the account as an inheritance. Inherited IRAs must be distributed within a specific time frame, which could force someone into a higher tax bracket than expected. In this scenario, converting the assets to a Roth account during retirement might make more sense if your income (and resulting tax rate) is lower, allowing your beneficiaries to avoid higher taxes on their inheritance.
Tax diversification is a vital component of a comprehensive financial plan. By thoughtfully spreading your investments across different account structures, you gain control over your tax liability and enhance your financial flexibility in retirement. Given the many variables involved, we recommend consulting with an experienced financial planner to determine an appropriate strategy tailored to your goals.
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