Tax Diversification With Investing

Defining Tax Diversification and How It Can Help You

••• Learn how tax diversification can help you keep more of your savings. Getty Images

Most investors understand the basics of diversification, which can be summed up in the sage advice, "Don't put all of your eggs in one basket." But too often investors limit their diversification to investment types and overlook its advantages in other areas, such as tax diversification.

Tax Diversification Definition

Tax diversification is a financial term that refers to 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, the amount of money you invest is not tax-deductible, nor does it grow tax-deferred. Instead, the investor is taxed on dividends, if any, during the year, and capital gains if and when the 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 With tax-deferred accounts, such as IRAs and 401(k)s, the money invested grows tax-free until withdrawn.

What Happens Without Tax Diversification

Conventional wisdom says to contribute all long-term savings, such as retirement savings, first to a 401(k), if available through an employer and at least up to the employer match, and then contribute to any other available funds to a Roth IRA.

In general, this is good advice. However, many investors make the mistake of maximizing their 401(k) above the employer match for the sole purpose of reducing current taxable income. Or they may make a serious mistake and invest more savings in a traditional IRA, instead of the Roth IRA, for a similar reason (current tax savings).

The reason this can be a mistake is that most or all of an investors long-term savings can end up being completely allocated to tax-deferred savings accounts. Why is this a problem? If all of your retirement savings are in tax-deferred accounts, such as a 401(k) and a traditional IRA, you could end up paying higher taxes if your only income source in retirement is from these accounts. Although contributions to these accounts are not taxable, the withdrawals are 100% taxable at the investors top federal income tax rate. Therefore, if tax rates go higher or if your tax bracket goes higher in your lifetime, either of which is possible, you could pay more in taxes than if you had other account types, such as taxable accounts and/or a Roth IRA.

Also, if you want to retire prior to the eligibility for full Social Security benefits, it can be smart to have accounts where withdrawals are taxed a lower rate (or not taxed at all) in those crucial first years of retirement.

For more on this, see my article: Is The Traditional IRA Dead?

Tax Diversification Benefits

As you may have already guessed, the benefits of tax diversification (spreading savings among various account types) is similar to investment diversification -- to reduce risk.

For example, the long-term capital gains tax rate for investments in taxable accounts is 15%. However, tax-deferred account withdrawals will be taxed at the top federal income tax bracket for the individual (or couple if filing jointly). This could be 25% or higher for many retirees.

Also, 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.

If you want to retire early, especially prior to age 59 1/2, when 401(k) and traditional IRA withdrawals will incur a 10% "early withdrawal penalty," having taxable accounts can be beneficial.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.