Tax diversification is an investment strategy that uses tax-advantaged, fully taxable and tax-free investment accounts to help lower taxes. Diversification is the name of the game when it comes to investing. This even applies to taxes. When you invest in accounts with different tax structures, you can save significantly on your tax bill both now and into retirement. But first, you need to understand how different investment accounts are taxed. Here’s how it works.
A financial advisor can help you optimize a tax strategy for your financial needs and goals.
Most traditional retirement accounts are tax-advantaged. This includes (401)k plans, 403(b) plan and traditional IRAs. A tax-advantaged account is a savings account that has been designed to make it easier for you to save money while reaping tax benefits.
Often, these types of accounts are created by Congress to incentivize saving for retirement. A 401(k), 403(b) or 457(b) plan has the tax advantage of coming straight from your paycheck before taxes, often with an employer match that accelerates your savings. Then you pay income taxes on the money when you withdraw it in retirement.
An individual retirement account or an IRA will charge you taxes upfront. But your withdrawals from an IRA in retirement are largely tax-free—you’ll only need to pay income taxes on the earnings of that account.
Fully Taxable Accounts
The fully taxable accounts you’re most likely to use are brokerage accounts. These accounts allow you to buy and sell stocks, bonds, exchange-traded funds (ETFs) and mutual funds most commonly. While these accounts can be an excellent source of investment income, they don’t come with any traditional tax benefits.
You fund these accounts with money you’ve already paid taxes on—no savings there. You’ll also have to pay taxes on what you earn from these accounts. You can see that unlike the above tax-advantaged accounts, you essentially pay taxes on these accounts twice.
Tax-free accounts aren’t actually tax-free per se. But like tax-advantaged accounts, taxes will only hit on one side of your investment. In this case, you’re taking the money you’ve already paid taxes on and investing it in an account where you won’t pay taxes when you withdraw the money. These accounts include Roth IRAs, Roth 401(k) plans, health savings accounts (HSAs) and 529 education savings plans.
HSAs and 529 plans were created to incentivize saving for medical costs and educational expenses, respectively. HSAs can be truly tax-free if your employer has a high-deductible health plan. Meanwhile, 529 plans can be used without incurring taxes as long as you only use them for qualified education expenses.
Roth IRAs and 401(k) plans are tax-free as long as you take them after the correct amount of time. Roth IRAs can be tapped into after the age of 59 ½ and Roth 401(k) plans after five years.
As mentioned above, while the money you deposited won’t be taxed, you will need to pay income tax on the earnings. So if you deposited $20,000 with interest and earnings, that amount is now $25,000, and the $5,000 earned will be taxed.
How Tax Diversification Works
So now that you understand how different accounts are taxed, let’s take a look at tax diversification and why it’s so effective. Like other investment diversification principles, tax diversification allows you to lower risk and put yourself in a more profitable position in the long run. There are three key benefits to tax diversification.
The first is lowering your overall tax bill. For instance, you can choose to withdraw from your tax-deferred accounts in early retirement, to lower your tax bracket and reduce the amount of taxes you pay over the life of the account. Diversified accounts allow you to make choices that save you tax money in the long term.
The second benefit is not getting hit by a huge tax bill all at once. If you save in both a Roth IRA and a 401(k) plan, you’re paying taxes upfront for the former and paying taxes when you withdraw for the latter. This saves you money in retirement, where a dollar might be dearer.
The final benefit is flexibility. If you have surprise expenses in retirement, not having to take a huge amount of out a tax-advantaged account that will push you into a higher tax bracket could be a lifesaver.
Like most financial topics, tax diversification is complex and can take many forms. You might take a simple tax diversification strategy by using both a 401(k) plan and a Roth IRA to save for retirement, spreading out your tax bill and risk over the lifetime of those accounts. Or you might want to take a more complex strategy and spread your savings over multiple instruments with different tax brackets and tax risks.
An additional challenge when planning for tax diversification is that tax laws are constantly in flux. The specifics of taxes, investments and retirement accounts are likely to change over time. Working with an expert can help you keep more of your money both now and when you retire.
Tax Planning Tips
- A financial advisor can help you optimize your financial plan to mitigate your tax liability. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Check what your income tax bill could be using SmartAsset’s free online calculator.
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