Tax Diversification and Investing

How to Reduce Taxes With Investing: Which Type of Account is Best?

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Tax diversification, as it relates to investing, refers to the strategic allocation of assets among multiple investment accounts with varying taxation. For example, when is it best to use a Roth IRA vs a Traditional IRA? Does it make sense to use 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 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 With tax-deferred accounts, such as IRAs and 401(k)s, the money invested grows tax-free until withdrawn.

Tax Diversification: 401(k) vs Traditional IRA vs Roth IRA

Which is best, a 401(k), a traditional IRA or a Roth IRA? It's possible that you'll have 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 is that there's no way to accurately predict what tax rates will be 10, 20 or 30 years from now. For this reason, it can be smart to have both. Also keep in mind that employer matching contributions are always made on a pre-tax basis. Therefore, even if you make Roth contributions to a 401(k), the match will be traditional.

Similarly, it can be wise to have a regular brokerage account in additional 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, which are lower than most federal income tax rates.

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 ta lower rate (or not taxed at all) in those crucial first years of retirement.

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% or 20%, depending on your income. 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 22% 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.

Bottom Line on Tax Diversification

The bottom line is that no one can predict what tax laws will do, especially decades in advance. Therefore, 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 in retirement, it can be wise to have assets spread across different account types, such as traditional IRA or 401(k) and Roth IRA and 401(k).

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