5 Advantages to a Tax Diversification Strategy and Why It Matters
January 9, 2022
First off, what is Tax Diversification?
Tax diversification is the practice of diversifying assets across different account types with varying tax characteristics. Since tax policies are always changing, tax diversification provides the flexibility to withdraw assets from optimal sources at preferred times to help preserve retirement assets. This strategy can help protect against higher tax rates in the future and improve the longevity of retirement assets.
There are several advantages to a tax strategy that employs tax diversification:
Flexibility
– Allows the ability to draw income from various sources
Creates a hedge against potentially higher tax rates in the future
May reduce overall taxes due to “bracket creep”
Portfolio longevity
– May help portfolios last longer
Pay Less Taxes in Retirement: Required Minimum Distributions (RMDs) can potentially push you into a higher tax bracket
It may be difficult to know if a portfolio is diversified from a tax standpoint. The worst thing to do is get an idea of the current tax situation, including income and the types of accounts where assets are held. Prior to undertaking any planning, it is essential to get a clear picture of the current situation and establish a starting point.
Current Tax Situation
Gauge exposure to taxes for the current year
This step is essential to understand possible planning strategies
Take Inventory
Getting a full picture of assets is essential
Divide holdings into three possible planning strategies – Currently taxable
– Tax-deferred
– Tax-free
Types of Accounts
Working with a financial professional, you can use different types of accounts to help diversify assets:
Traditional 401(k), 403(b), or IRA: May offer a tax deduction when you contribute, but you’ll have to pay taxes when you withdraw the money in retirement. These accounts require minimum distributions when you reach a certain age.
Roth 401(k), 403(b), or IRA: No tax deduction when you contribute, but funds grow tax-deferred and qualified withdrawals are tax-free. On Roth IRAs, income limits apply to who can contribute and there are no required minimum distributions during the original owner’s life.
Taxable savings or brokerage account: Tax is paid annually on any dividends and interest. Capital gains are taxed when assets are sold.
Understanding the pros and cons of different types of accounts and their tax attributes is essential in developing a strategy. Each type of account has different characteristics, rules, and nuances. To help understand broadly where assets are held and their tax treatment, break them up into groups, such as currently taxable, tax-deferred, and tax-free.
See the chart below to understand some of the various types of accounts:
The Tax-Free Category
It is likely the tax-free category will have the least amount of assets. There are fewer ways to fund this category, placing natural limitations on it. Being mindful of the tax-free category and funding it where possible should be a goal. Below is a synopsis of some of the tax-free account options:
Roth Conversions
If someone believes tax rates will be higher in the future, it may make sense to convert some pretax retirement accounts to Roth accounts. The idea is to convert at lower tax rates now to increase tax-free sources of income in the future when tax rates could be higher. Roth conversions need to be carefully considered, and it is always recommended to speak with financial and tax professionals before doing so.
Municipal Bonds
Municipal bonds can also be a possible source of tax-free income. A municipal bond is a bond issued by state or local governments. In the United States, interest income received by holders of municipal bonds is often, but not always, exempt from federal taxation. Municipal bonds may also be exempt from state taxation depending on the type of bond purchased and your state of residency. An additional advantage to municipal bonds is there’s no contribution limit. One disadvantage is the interest from the bond may be lower than other investment options due to its tax-free nature.
529 Plans
There are certain accounts that can provide tax- free usage based on specific criteria. The proceeds from a 529 plan are tax-free assuming they are used for qualified higher education expenses for a beneficiary. Assuming education is a goal, the use of a 529 plan can add to the tax-free category.
Health Savings Accounts (HSAs)
A type of savings account that allows money to be set aside on a pretax basis to pay for qualified medical expenses tax-free. There is a penalty for using funds for purposes other than health expenses. At age 65, proceeds can be used for non-health purposes but will be taxed as ordinary income when withdrawn.
Life Insurance (Loans and Death Benefits)
Cash value in life insurance policies may be accessed through tax-free loans from the policy. Also, life insurance death benefit proceeds are generally free of income tax.
In The End…
There is no single way to properly plan for taxes.
With all of the variables and complexities involved, it is highly suggested to make careful decisions informed by the right financial professionals. Taxes do not exist in isolation or in a vacuum. Even the best laid plans may require monitoring or adjustments with changes to tax laws. An individual’s priorities may also create the need for more or less tax planning. With education, planning, and a desire to understand your situation, planning for taxes can have a positive impact on your well-being and finances.
Thank you for reading and sharing.
Until Next Time…
If you would like us to review your current financial situation or portfolio please email us at info@commonfinancialsense.com
