Diversify Your Diversification Strategy

Diversification is one of the most commonly used terms in financial planning. Most people know they should invest in both stocks and bonds, own U.S. and international securities, and buy large cap and small cap stocks. However, there is another way to diversify your portfolio that could produce significant savings: tax diversification.

Diversification is important because we can’t predict the future. Will value stocks outperform growth stocks next year? Since we don’t know, it is wise to invest in both so part of our portfolio is likely to benefit regardless of what happens.

Will your earned income cause you to be in a higher or lower tax bracket when you retire? Even more abstract is the question of whether income tax rates as a whole will be higher or lower in the future. Further, how will the capital gains tax rate compare to the ordinary income tax rate 10, 20, or 40 years from now? Again, because we can’t predict the future, tax diversification may be useful.

Tax-deferred accounts such as 401(k)s or traditional IRAs enable you to delay paying taxes on today’s income until you withdraw it during retirement. These accounts are useful if you will be in a lower tax bracket during retirement. Contributions to tax-free accounts such as Roth 401(k)s or Roth IRAs do not allow a tax deduction now, but all growth on your investments can be withdrawn tax free during retirement. Tax-free accounts are valuable if you will be in a higher tax bracket after you retire. Finally, growth on investments in a taxable brokerage account is subject to capital gains tax, which is currently favorable compared to the ordinary income rate.

If you don’t know your future tax bracket, you can hedge your bets by investing in both tax-deferred and tax-free accounts. Further, since we are unclear how the capital gains rate will compare to the ordinary income rate in the future, investing in a taxable account may also have a purpose.

Tax diversification offers other benefits. Both tax-deferred and tax-free accounts can’t typically be accessed before age 59.5 without a 10 percent penalty. However, early retirees could draw from a taxable account in years before they are allowed to take penalty-free withdrawals from their retirement accounts. Further, required minimum distributions (RMDs) from tax-deferred accounts must begin at age 70.5. Meanwhile, RMDs aren’t required from taxable and tax-free accounts. Thus, having part of your portfolio in these accounts can prevent you from having to withdraw more than you want, which can lower your tax bill and allow for more tax-free growth.

Having various investment accounts can also lower your marginal tax rate. Someone withdrawing $100,000 a year from a tax-deferred account would fall into the 25 percent federal tax bracket. On the other hand, if the individual withdrew $50,000 from a tax deferred account and $50,000 from a tax-free or fully taxable account, which doesn’t count as earned income, the investor would be in the 15 percent tax bracket.

Speak to a fee-only financial planner to learn if you could benefit from this strategy.