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My assets are tax diversified partly as a result of happenstance. But now that the concept is becoming more popular, I am embracing tax diversification as a strategy for cost savings and asset preservation.
What is tax diversification? It’s holding investments within accounts that have differing tax treatments. More importantly, why does tax diversification matter? With appropriate diversification, I may have greater opportunity to control my tax bill during retirement and even before retirement. By limiting my tax bill, I could possibly reduce my overall expenses and preserve more of my wealth.
There are a few main types of tax-related account structures
When reading about tax diversification, I’ll typically come across these classifications:
- tax-deferred: this structure allows me to defer taxes on investment earnings as I accumulate wealth; when I withdraw money, I’ll pay taxes generally at ordinary income tax rates
- tax-exempt: this type of account enables me to avoid taxes on investment earnings during wealth-accumulation years and skip taxes on withdrawals when I withdraw money for spending
- taxable: this structure requires me to pay taxes on investment gains and dividends; generally, though, I’ll pay a relatively low capital gains tax rate on investments held in this type of account when I hold assets for more than a year (otherwise I’ll pay short-term capital gains tax rates, which are equivalent to ordinary income taxes)
When thinking about retirement and long-term savings, the following types of accounts may come to mind based on these classifications:
- Traditional IRAs and traditional 401(k)s – tax-deferred: money held inside these accounts grow tax-free until I take make a withdrawal; when I take distributions from these accounts in retirement, I’ll pay taxes at ordinary income tax rates on the money I withdraw; generally, I’ll reduce my income taxes when I make contributions during my working years
- Roth IRAs and Roth 401(k)s – tax-exempt: withdrawals from these types of accounts typically don’t incur income taxes; however, I won’t get a tax break when I make a contribution
- Regular brokerage accounts – taxable: simply holding investments in regular brokerage accounts can trigger tax liabilities; I’ll owe taxes associated with investments when I receive interest and dividends, sell investments and realize a capital gain, and hold mutual funds that pass through capital gains and dividends; however, if I have a capital loss, I can use that loss to offset a gain
There are other types of accounts that fall under one of these classifications. These include:
- Municipal bonds – tax-exempt: generally, interest on municipal bonds is exempt from federal income tax (and may be exempt from state income taxes)
- Variable annuities – tax-deferred: earnings that accumulate within a variable annuity are typically tax-deferred and withdrawals are taxed at ordinary income tax rates
- 529 Plans – tax-exempt: generally, earnings on investments held in 529 Plans are not taxed by the federal government; plus I can withdraw funds free of federal income taxes to pay for qualifying college expenses
- Health savings accounts – tax-exempt: earnings grow tax-free, withdrawals for qualified medical expenses are tax-free, and contributions reduce my tax liability according to the IRS
- Primary residence sale – tax-exempt (within certain limits): gains on selling a primary residence are largely tax-exempt up to limits ($250,000 for a single person, $500,000 for married couples filing jointly)
There are benefits to both tax-advantaged and regular taxable accounts
There are many nuances relating to various account structures and tax laws. For starters, when I reference tax-deferred or tax-exempt, generally I am referring to treatment of federal income taxes. Very often, state income tax treatment is the same but not always.
Further, investments in these accounts could incur taxes that aren’t typically income taxes. For example, I may have to pay property taxes on my primary residence or intangibles tax on securities held in a regular brokerage account.
In retirement, I may owe taxes on Social Security benefits if my combined income reaches a certain threshold; and combined income may include tax-exempt interest from municipal bonds.
Also, there are quirky rules associated with owning and funding some of these accounts. For example, if I don’t have a high-deductible health insurance policy, then typically I can’t get a health savings account (HSA). Roth 401(k)s or even 401(k) plans may not be available at my employer. Finally, in some years, I could make too much money to contribute to a Roth IRA.
Tax laws are complex and subject to change. The point of tax diversification is to position assets in a way that provides flexibility in various scenarios. These situations may include times when the rules change, I have an unusual tax situation, or I want to limit my tax liability.
So, let’s consider how withdrawals from various accounts, done strategically, could be beneficial.
Having money in various types of accounts can be helpful at all stages of life
When I first thought about tax diversification, I considered how having accounts with various structures could be beneficial in retirement. But then I realized that it could be helpful well before retirement.
Pre-Retirement Tax Diversification
Let’s say I’m young but I’ve been able to accumulate investments now valued at $50,000. Let’s look at what would happen if I needed $5,000 to pay for medical bills and $10,000 to buy a car.
If I had money in a variety of accounts, I could largely avoid incurring income taxes on my withdrawals. On the other hand, if I had saved within a traditional 401(k) plan at work, then I’d have a more difficult time accessing my money.
In scenario A, let’s say I had $10,000 in each of the following types of accounts:
- Traditional IRA
- Roth IRA
- Regular brokerage account
- Health Savings Account
- Traditional 401(k)
I could easily pay medical bills with money inside of my HSA. I’ve already gotten a tax break for putting money in the HSA and now I’m avoiding having to pay income taxes on the withdrawal for qualified medical expenses.
In addition, taking money out of my regular brokerage account is pretty easy. Let’s say I bought shares of Company ABC for $5,000 a few years ago and now they’re worth $10,000. I may owe capital gains taxes on the $5,000 gain (proceeds less cost) but my tax rate could be as low as 0% if married and my joint taxable income with my spouse is as low as $74,900.
On the other hand, in scenario B, all of my money is held in a traditional 401(k). Depending on the plan’s design and the amount of my bills compared to my income, I may be able to claim a hardship to withdraw money for medical bills. But typically I’ll pay taxes on the early distribution at my ordinary income tax rate and possibly owe a 10% penalty.
So, being tax diversified could save me hundreds or thousands of dollars depending on my unique tax situation.
Tax diversification in retirement
In retirement, I’ll also withdraw funds from my accounts though typically won’t incur penalties. The White Coat Investor describes a scenario in which retired physicians both withdraw $100,000 in one year but incur dramatically different tax bills due to diversification.
In my illustration, I’ll consider what could happen if a married retiree generated an annual income of $45,000 with $5,000 designated for healthcare expenses.
In the first scenario, money is held in a Roth IRA, Traditional IRA, and HSA. These amounts are withdrawn to pay for living expenses:
- Roth IRA: $19,400
- Traditional IRA: $20,600
- HSA: $5,000
Funds from the Roth IRA and HSA are tax-exempt. Money from the traditional IRA is subject to income tax. But if this retiree is married and the couple takes the standard deduction, married filing jointly, then the taxable income should be $0.
In a different scenario, if a retiree had withdrawn all living expenses from a traditional IRA, then the taxable income would be $24,400. Using tax tables published in Forbes, income tax on this withdrawal could be $3,198.75 [$922.50 + ($24,400-9,225)x.15%].
Now, my withdrawals and tax bills in retirement probably won’t work out this neatly. But having tax diversification should still help me control taxes in the future. Controlling taxes could allow me to spend less, withdraw less money held in investments, and preserve wealth.
Still, everyone’s situation is different. These scenarios consider only the tax treatments of money being withdrawn either before retirement or during retirement. Savers and investors may have benefited from tax savings when they made contributions to traditional IRAs and traditional 401(k)s, leading to bigger balances.
My point is not to suggest a specific course of action relating to tax diversification or an even split of funds among accounts with various tax classifications. My purpose in discussing tax treatment of various types of accounts and offering these illustrations is twofold: 1) explain the concept of tax diversification and 2) explore the possible benefits of tax diversification.
Knowing about tax diversification is useful as I plan on my own or work with a team of financial advisors, planners, and tax professionals.
Have you intentionally used tax diversification as a planning strategy? Are you considering tax diversification now?