Most people are familiar with the concept of diversification within their investment portfolio. The idea behind diversification is to own a variety of different asset classes that are not highly correlated with each other. For example, sometimes stocks perform better than bonds, other times bonds outperform stocks, and other times real estate outperform both stocks and bonds. Owning a variety of asset classes allows you to generate returns and offset losses from different assets at different times. This is a risk management strategy that allows investors to benefit from the unpredictability and volatility of the market by keeping them invested through good and bad times.
You could compare a well-diversified portfolio to a well-balanced diet. If you have a well-balanced diet, you eat a variety of different foods that provide the nutrients your body needs to function at its best. You may have some protein for muscle growth and health, fruits and vegetables for the vitamins and minerals they provide, water to stay hydrated and some carbs to fuel your body’s vital processes. If you only eat carbs and nothing else, you will experience a decline in your body’s ability to function optimally and it could lead to an overall decline in your health and wellbeing. Investing is similar in that if you put “all of your eggs in one basket” you’re essentially investing in the success of one company, one sector of the market, or one asset class.
Tax diversification takes this concept a step further by understanding the implications of “putting all your eggs in one basket” regarding the investment vehicles that you are using. For example, if you have all your retirement funds in a 401(k), when it is time to start distributing those funds for income, you will pay ordinary income tax rates on those distributions. Other income such as Social Security or pension benefits are also taxable and would add to the taxable income generated from 401(k) distributions. This does not provide many options for generating income in a tax advantaged way.
Alternatively, tax diversification is utilizing multiple investment vehicles that have different tax rules. We’ll discuss three of the most common investment vehicles used today, Roth IRA (and Roth 401(k)s as more employers are adopting them), Traditional IRA (and 401(k)s), and a Taxable Investment Account.
With Traditional IRAs and 401(k)’s you get a tax deduction in the current year that the contribution is made. For example, if you earn $100k and max out your Traditional IRA contribution of $7k (for those under age 50), then your taxable income would be $93k. You do not have to pay taxes on the amount contributed in the current year, however, when you pull funds out of your IRA in retirement, your contributions, earnings, and growth are taxable at ordinary income tax rates, whatever those may be at the time.
Roth IRA’s offer no tax deduction in the current year, therefore, if you earn $100k and max out your Roth IRA contribution of $7k, then you will still owe income tax on the full $100k that you earned. The difference is that the contributions, associated growth, and earnings are not subject to income taxes when you pull money out in retirement. This gives you the benefit of tax-free growth and distributions by sacrificing the current income tax deduction.
Finally, let’s review taxable accounts. These accounts are very flexible. They do not have a limit on how much money you put in or when you can take money out. You do not get tax benefits in the current year for contributions made into this investment account. The benefit is how the funds are taxed when you experience growth and earnings of your investment. Depending on the holding period, the funds are either subject to ordinary income, or capital gains taxes. Currently, capital gains taxes are either 0%, 15% or 20% depending on your income. Also, keep in mind, you only pay taxes on the growth and/or earnings of your investment (you may also realize loses that can help offset other taxes, this is a topic for another article).
By using a combination of investment vehicles, you give yourself the opportunity and flexibility to generate income from a variety of different accounts that could help reduce your overall tax burden. Asset allocation and tax diversification are just the beginning when it comes to long term financial planning.