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Most people are familiar with portfolio diversification, which is a fancy way of saying “don’t put all your eggs in one basket,” but fewer people think about tax diversification. It’s the same idea, except instead of investments, it’s about strategically spreading out your tax risk—because tax rates can change unexpectedly over time.
When you are taxed varies by investment type
Tax diversification is focused on when you’ll be taxed on your investments. Because different types of investments vary on when taxes kick in, you have some flexibility to spread your tax risk out over a lifetime. After all, the difference between tax rates of 10% and 37% is considerable when you’re talking about hundreds of thousands of dollars.
As Kiplinger explains, these are the three basic categories of investments, based on when they’re taxed:
Taxed always: Holdings for which you’re required to pay income taxes annually, such as investment brokerage accounts (or even checking accounts), which may produce interest, dividends, realized capital gains, and/or capital gains distributions.Taxed later (deferred): Holdings for which you’re only required to pay taxes upon withdrawal/distribution—like a 401(k) or 403(b)—or when any capital gain is realized, like many forms of real estate or other hard assets.Taxed rarely: Holdings for which you’re rarely, if ever, required to pay income taxes, like a Roth IRA, interest from municipal bonds, and certain types of specially designed life insurance.G/O Media may get a commission
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How tax diversification works
To illustrate how tax diversification would work, imagine that you put all your money into a 401(k), which is a “tax later” investment account. Most people do so assuming they’ll be in a lower tax bracket later in retirement, but that’s not necessarily the case. As Kiplinger points out, every dollar withdrawn from a 401(k) is considered ordinary income—the same as if it were coming from your monthly paycheck while you were still working. Therefore, it’s possible that you could still pay the same tax rate in retirement that you do now (your lifestyle isn’t necessarily going to be cheaper in retirement, either, as is commonly assumed).
Plus, with 401(k)s we’re talking about decades of deferred taxes. There is no way to know if your income bracket will change in the future due to tax policy changes. You can’t automatically assume your tax rate will stay the same.
This is where tax diversification comes into play. Using the same example, you could spread out your tax burden by splitting your investments between a 401(k) and a Roth IRA, which is a “tax rarely” investment account (although you’ll want to max out your 401(k)’s employer matching contributions first, if you can).
Roth IRAs are “tax rarely” (or “after-tax”) in that you pay taxes on the income before you actually deposit it into your Roth account and the withdrawals are tax free (after the age of 59.5). Whatever is left is yours to grow tax-free for as long as you have the account (there are contribution limits and restrictions based on income, however).
In this way, a Roth IRA is basically the opposite of a 401(k) in the way it’s taxed. By having both types of accounts, however, you would have more flexibility to mix your withdrawals later based on tax bracket considerations. For example, maybe a smaller required distribution from an 401(k) plus a tax-free Roth IRA withdrawal could keep you in a lower tax bracket compared to relying solely on the 401(k).
Bottom line
Since tax diversification depends on many factors like your age, income, lifestyle, and retirement plans, you should consult a financial advisor to help you navigate through all of your investment options. Life events can easily change your priorities, too, so it’s best to think of tax diversification as an ongoing conversation about what’s best for you rather than a fixed plan.
