Most investors understand the importance of maintaining a well-diversified asset allocation consisting of a wide variety of stock mutual funds, fixed income investments and real estate. But you may be less aware of the importance of building a portfolio that provides you with tax diversification.
Tax diversification is achieved by investing money in a variety of accounts that will be taxed differently in retirement. With traditional retirement vehicles such as 401k plans and traditional IRAs, your contribution is currently deductible from your taxable income, your contribution will grow tax deferred and you will pay regular income taxes upon distribution in retirement. Generally, you can’t access this money without a penalty before 59 ½ and you must take Required Minimum Distributions at 70 ½. This may be a good option during your peak earning years when your current tax bracket may be higher than it will be in retirement.
Another great vehicle for retirement savings is a Roth IRA or a Roth 401k which is not deductible from your current earnings. Roth accounts grow tax free and can be withheld tax free in retirement, if held for at least five years. If possible everyone should contribute some money to a Roth and they are especially good for investors who are currently in their lower earning years.
A third common way to save for retirement is in a taxable account. You invest in a taxable account with after tax money and pay taxes on interest and dividends as they are earned. Capital gains are generally paid at a lower rate upon the sale of the investment. In addition to liquidity, some benefits of a taxable account include the absence of limits on contributions, the absence of penalties for early withdrawals and absence of required minimum distributions.
Once you reach retirement it’s beneficial to have some flexibility in the type of account from which you pull retirement funds. In some years you can minimize income taxes by pulling from a combination of 401k, Roth and taxable accounts to avoid going into a higher income tax bracket. This may be especially helpful in years when you earn outside income, sell taxable property or take large withdrawals to cover big ticket items like a car. Another way to save taxes is to spread large taxable distributions over two years.
Additionally, by strategically managing your taxable distributions you may be able to minimize tax on your Social Security benefit. Your taxable income can also have an impact on deductions for medical expenses and miscellaneous itemized deductions, which must exceed a set percentage of your income to become deductible. In years with large unreimbursed medical or dental expenses you may want to withdraw less from your taxable accounts.
Finally, there may be major changes to tax rates or the tax code in the future. A Tax diversified portfolio can provide a hedge against major changes from future tax legislation.