If you’ve worked with us for any length of time, you’ve certainly heard the term diversification once or twice as it relates to investments. You may not be as familiar with the term “tax diversification” but know that it is a relevant concern that we consider when recommending your savings options.
Tax diversification refers to having different portions of your savings subject to different tax rules, which becomes especially important when you begin making withdrawals during retirement. The alternatives are: 1) tax deferred savings (IRA, 401k, 403b, SIMPLE IRA), 2) tax-free savings (Roth IRA/401k) and 3) taxable savings in your single name or joint name.
The reason tax diversification is important is that we don’t have control over the tax environment when we reach retirement. Having access to funds that are treated differently from a tax standpoint may allow you to access the funds you need without paying more taxes than necessary.
The primary tax deferred savings vehicles for individuals are the “Traditional” IRA and employer sponsored retirement plans. These vehicles often provide tax breaks in your prime earning years, may have an employer match, and have relatively high contribution limits. If you’ve done a good job saving in these vehicles, you are typically a happy retiree. Your happiness wanes in April when you realize that the money you’ve withdrawn from your nest egg is fully taxable at the rates that could be as high or higher than the rates paid on your salary and you have no way to avoid the tax bill by instead taking from elsewhere.
In order to create tax diversification among your investments, planning needs to begin early. Early career individuals have the ability to make Roth IRA contributions which are limited by income; with maximum contributions being limited for singles who make over $122,000 and married couples over $193,000. The maximum annual Roth IRA contribution is $6,000. If your company offers one, a Roth 401k would allow for an additional $19,000 to be put away in in tax free savings (and it is not subject to income limitations). Even if Roth assets equal only 10-20% of your net worth at retirement, the flexibility it provides is very valuable. As your salary and tax bracket increases over time, you may become ineligible for Roth IRA so making the contribution while you’re eligible is timely.
Taxable accounts in your single or joint name are also very valuable and become especially valuable after you become ineligible for Roth IRA contributions. These can be a great mid and late career investment vehicle after maximum employer retirement plan contributions are made. Taxable investment accounts can be an excellent place to set aside your bonus. Taxable investment accounts have no income limitations for contributions and have no maximum contributions. Withdrawals are taxed at lower capital gains rates if there are built in gains. They are also a great legacy asset as they receive a step up in basis at death.
Realizing that all situations and timelines are different, it’s important to review your individual situation periodically with your advisor and your CPA to ensure that you are taking advantage of all possible savings vehicles available to you. The long-term benefits of these decisions are large and they are best made early. Please contact your DHG Wealth Advisor regarding how tax diversification can provide benefit to your overall financial picture.
The attached article provides some additional information on the topic: