Diversification is a core theme in modern investing. Generally, it is a good idea to have a broad mix of investments to reduce portfolio risk in the event a particular stock or company goes under. Essentially, diversification acknowledges that we cannot predict the future for any single asset.
That same concept of reducing risk through broad exposure can also apply when selecting the types of accounts that will hold retirement savings from a tax standpoint.
The three major types of accounts that investors use to save for retirement are:
- taxable accounts
- tax-deferred accounts
- tax-free accounts
Tax diversification is a strategy that encourages investors to be knowledgeable about the tax attributes of different accounts and intentional when funding these accounts.
Taxable accounts are typically simplest to fund and maintain as there are no limits on contributions or rules requiring distributions at a certain age. A taxable account is funded with "after tax" dollars which means a tax deduction is not provided for funding the account. These accounts can be a standard brokerage account where investors purchase securities like stocks, bonds, and mutual funds.
With a taxable account the investor will pay tax each year on income generated by the holdings such as interest and dividends. When an investor decides to sell investments in a taxable account, capital gains tax will apply to the extent sales proceeds exceed the tax basis (typically tax basis is the original purchase price). In a taxable account the capital gains tax rate for assets held more than a year is lower than the tax rate for ordinary income.
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Tax-deferred accounts are one of the most common dedicated retirement savings vehicles. Many workers who participate in a Traditional 401(k) or Traditional IRA are already familiar with this type of account. These accounts are typically funded with "pre-tax" dollars which means the contribution reduces taxable income for the year.
Once funds are inside a tax-deferred account, the owner will not owe tax until the funds are later withdrawn from the account, regardless of the investment activity within the account. This is where the name "tax-deferred" originates, income from interest, dividends, and capital gains will not be taxed within the account, rather the owner is only taxed later when funds are withdrawn from the account.
Account owners may be penalized if funds are withdrawn from a tax-deferred account before age 59 ½. Tax-deferred accounts will often require the owner to begin withdrawing required minimum distributions (RMDs) from the account at a certain age, and distributions from tax-deferred accounts are usually taxed as ordinary income. The IRS limits the amount that can be contributed per year to a tax-deferred account like a 401(k) or IRA.
Tax-free accounts are typically denoted by the word "Roth" in the title, like a Roth IRA or Roth 401(k). Tax-free accounts are funded with "after tax" dollars (like taxable accounts) which means a tax deduction is not provided when contributions are made.
However, if the IRS rules are followed, all of the income and all of the gains in a tax-free account can be withdrawn in retirement totally free of income tax. In many cases, the owner of a tax-free Roth IRA account has more flexibility to withdraw contributions from the account before age 59 ½ without a penalty.
Additionally, unlike tax-deferred accounts, tax-free Roth accounts do not force the account owner to take RMDs at a certain age. The IRS limits the amount that can be contributed per year to a tax-free account like a Roth 401(k) or Roth IRA. In some cases, a high earning individual may be prohibited from contributing directly to a Roth IRA.
Tax Diversification Strategy
The greatest benefit of funding different account types and being diversified from a tax standpoint is flexibility. It is impossible to guarantee what the tax brackets, RMD rules, and capital gains tax rates will be at any point in the future. Having tax diversified accounts will allow a retiree to use their capital in the most tax efficient manner regardless of how the rules change.
Tax diversification also encourages investors to be mindful when funding retirement accounts. In high income years when a worker is subject to higher tax rates it may make more sense to fund tax deferred accounts to get a current tax deduction.
In lower income years when a tax deduction isn't as useful, funding tax-free accounts may be the ideal long-term solution. It is important for investors to be educated on all available options and thoughtfully prepare a financial plan. Competent advice from a qualified tax advisor or CPA is also critically important.
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TD Wealth does not provide legal, tax or accounting advice to its clients. This article contains general information only. It is being provided solely for educational purposes. It is not intended to provide individualized recommendations or personalized tax advice. The tax strategies mentioned here may not be suitable or tax efficient for you. You should review your tax situation with your legal counsel, independent tax advisor and accountant/CPA prior to making any decisions.
Federal and state tax rules and requirements are subject to frequent change. TD Wealth does not provide legal, tax or accounting advice to its clients. This article is not a substitute for such professional advice or services. It should not be relied upon by you, your estate, your fiduciaries, or any of your beneficiaries as legal or tax advice or as a basis for any decision or action that my affect your taxes or finances. Prior to making any decision or taking any action that may impact your tax plan, you should consult with your attorney, independent tax advisor and accountant/CPA for a complete analysis of the legal and tax implications applicable to your particular situation.
If there are any errors or omissions, you understand that this summary is general in its scope; educational only in nature; and may not be relied upon as legal or tax advice in making any determination whether to take action. TD Wealth shall not be responsible for any loss sustained by any person who relies on this summary.