Tax diversification, as it relates to investing, refers to the strategic allocation of assets among multiple investment accounts with varying taxation. For example, tax diversification can help an investor choose between using a Roth IRA or a traditional IRA. It can help investors determine when to use a regular brokerage account instead of an IRA. The best application of tax diversification may require using all three accounts.
Tax Diversification Definition
Tax diversification is the allocation of investment dollars to more than one account type. Tax diversification is similar to asset location (not to be confused with asset allocation), which refers to spreading investment dollars among various account types (the location of the investment assets) and choosing the best investment types that work best in those accounts.
The two basic types of investment accounts are taxable accounts and tax-deferred accounts. When you invest in taxable accounts, such as a regular brokerage account, the amount of money you invest is not tax-deductible, nor does it grow tax-deferred. Instead, the investor is taxed on any dividends received during the year, as well as on capital gains—if and when an investment is sold at a price higher than it was purchased. With tax-deferred accounts, such as IRAs and 401(k)s, the money invested grows tax-free until withdrawn.
Tax Diversification: 401(k) vs. Traditional IRA vs Roth IRA
Many investors wonder which is best: a 401(k), a traditional IRA, or a Roth IRA. You may want a combination of all three. The general rule of smart personal finance is to always contribute at least enough to a 401(k) to receive the full employer match. If you can afford to save more for retirement, invest that money in a Roth IRA.
When choosing between traditional (pre-tax) and Roth (after-tax) contributions, the general rule is to use a traditional IRA or traditional 401(k) if you expect to be in a lower tax bracket in retirement. If you expect to be in a higher tax bracket in retirement, use the Roth IRA. If you are in the same tax bracket in retirement as you were while making the contributions, the traditional and Roth have equal benefits.
The challenge in choosing between traditional and Roth IRAs is that there's no way to accurately predict what the tax rates will be 10, 20, or 30 years from now. For this reason, it can be smart to have both types of retirement accounts. Keep in mind that employer matching contributions are always made on a pre-tax basis.
Similarly, it can be wise to have a regular brokerage account in addition to your retirement accounts because of taxation. All qualified retirement accounts grow on a tax-deferred basis, and withdrawals are taxed as ordinary income. However, withdrawals from taxable accounts (from the sale of securities, such as stocks or mutual funds) are taxed at capital gains rates. Roth IRAs are a little different, because the contributions are after-tax, and qualified withdrawals are made completely tax-free.
If you want to retire before you become eligible for full Social Security benefits, it can be smart to have accounts where withdrawals are taxed at a lower rate (or not taxed at all) in those crucial first years of retirement.
Tax Diversification Benefits
As you may have guessed already, the benefits of tax diversification (spreading savings among various account types) are similar to those of investment diversification—it reduces risk. For example, most people pay a long-term capital gains tax rate of 15% for investments in taxable accounts (though the exact rate will depend on your income level). For retirees who withdraw at least $40,526 throughout the 2021 tax year ($81,051 for married couples filing jointly), this tax bracket rate would be at least 22%.
You will get the most out of tax deferral by leaving your 401(k) and traditional IRA money untouched and growing tax-free as long as possible. Therefore, it is wise to withdraw from taxable accounts and Roth IRAs first in retirement and to withdraw from tax-deferred accounts later.
The Bottom Line
No one can predict what tax laws will do, especially decades in advance. Investors should carefully think about possible taxation scenarios in retirement before making long-term decisions on the types of accounts to invest in. For example, it's wise to consider the chances of being in a higher tax bracket or a lower tax bracket in retirement and then invest accordingly.
If you're not sure what tax bracket you'll be in during retirement, it can be wise to have assets spread across different account types, such as a traditional IRA or a 401(k) or a Roth IRA.