Beyond Traditional Diversification: Tax Diversification

Diversification is an important strategy to reduce idiosyncratic risk in investment portfolios.  Most investors are familiar with the concept of diversification and you have probably heard the phrase “Do not put all your eggs in one basket.” However, oftentimes investors overlook the tax ramifications that are embedded when investing in the markets. Investors want to get the highest return with the lowest amount of risk which is a rational thing to do. However, they neglect to incorporate the tax burden behind it. A more thoughtful approach when investing should not only focus on the market but also on tax risk-reward tradeoff. The ultimate goal is to enhance your after-tax returns on your investment portfolio with the least amount of risk.

As Benjamin Franklin said once, “There are only two things certain in life: death and taxes.” Today the U.S. government is facing uncharted waters with a ballooning national deficit that has been exacerbated by the pandemic with $28.1 trillion of national debt, making a tax increase inevitable in the long run. It is for this reason that tax diversification is an important concept to be included in any investment strategy for individuals. 

Tax diversification is a strategy that considers the allocation of funds across different account types with the objective to gain flexibility to make timely decisions as personal income and the tax code change over time. The three basic types of investment accounts are: taxable, tax-deferred, and tax-free accounts. 

Taxable 

When investing in taxable accounts, such as brokerage accounts, the money you invest is funded with after-tax contributions, non-tax-deductible, which means it is funded with the actual take-home pay. The dividends and interest on the investments are taxed as ordinary income and the capital appreciation of the investments is taxed only if sold at capital gain tax rates. Qualified dividends are taxed at capital gain tax rates.  

Tax-Deferred 

Money invested in tax-deferred accounts or qualified retirement accounts – traditional IRAs, 401(k)s, 403(b)s, 457(b)s, etc. – is tax-deductible and grows tax-deferred until the funds are withdrawn from the account. Distributions are taxed as ordinary income rates and there may also be a 10% penalty if distributions are taken out prior to age 59 ½. The timing of the withdrawals is paramount for a tax-efficient withdrawal strategy as the distributions can put you in a higher tax bracket. 

Tax-free 

When investing in tax-deferred accounts, such as Roth IRAs, Roth 401(k)s, 529s, 457(bs), life insurance (cash value), etc., the money in these accounts is funded with after-tax contributions (non-tax-deductible) and grows tax-free. Distributions are generally tax-free, non-considered income for tax purposes when certain conditions are met.

One more type of account that can be incorporated into your retirement plan is a Health Savings Account. This type of account has the best outcome of both worlds: it is tax-deductible and tax-free so long as distributions are met to meet medical expenses. This account is the most tax-efficient of all and therefore the tax risk is mitigated when distributions are used properly for medical expenses.

How to capitalize tax diversification

We have a married couple, Linda and Michael Jones, who are in the accumulation phase in their careers. They are in the 22% income tax bracket and are starting to fund their investment accounts. Believing that they will be in a higher tax bracket due to great career aspirations in the near future and the ballooning national deficit, they have decided to pay taxes today and opt to fund with after-tax contributions their tax-free accounts – Roth IRAs, Roth 401(k)s, 529s, 457(b)s, permanent life insurance – as well as their regular taxable accounts. Ten years later, they see their income tax bracket go up, based on higher earnings and tax increases, and they find themselves in the 35% income tax bracket. At that point, they switch their funding to only tax-deferred accounts – traditional IRAs, 401(k)s, 403(b)s, 457(b)s, HSA accounts, etc. –  to minimize taxes on contributions until retirement. 

Let’s fast forward twenty years later when Linda and Michael go into retirement. At that point, they find themselves in the 24% tax bracket and if they only withdraw $160,000 from their tax-deferred accounts (traditional IRAs), they would be left with a net income of $121,600, assuming a 24% tax rate. However, if they withdrew $40,000 from each of the four types of investment accounts – taxable, tax-deferred, tax-free, and Health Savings Account – they could potentially receive a net income of $144,400, assuming a 24% income tax bracket and 15% in capital gains taxes for a total difference of $22,800 additional net income or about 14% of savings in taxes.

An additional benefit of tax diversification in your withdrawal strategy is that it gives you flexibility and potentially the opportunity to reduce the tax liability from collecting social security benefits. Up to 85% of social security benefits might be subject to income taxes if your income exceeds certain thresholds. Also, income thresholds can affect other benefits, such as Obamacare subsidies where your subsidy can be maximized or the standard monthly Medicare Part B premium can be minimized. Currently, the lowest premium on Medicare part B is $148.50, but could go as high as $505 depending on your income. 

As you can see, the idea behind tax diversification is to fund all the different types of accounts to an optimal level before retirement to provide flexibility down the road and create a tax-efficient withdrawal strategy to help your assets last longer in retirement. If you are early in your career, consider tax diversification as part of your overall investment strategy for retirement.

To discuss in more detail the different strategies available to fund the different types of accounts, and to understand better your current financial situation and moving towards financial freedom, do not hesitate to contact me.

Sources:

U.S. Department of the Treasury. Fiscal Service, Federal Debt: Total Public Debt [GFDEBTN], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GFDEBTN, July 26, 2021.