What Is Tax Diversification, and Why Does It Matter for Your Retirement?

Benjamin Franklin famously said, “In this world, nothing is certain except death and taxes.” Since paying taxes is inevitable in retirement, an effective tax diversification strategy can help preserve your financial resources longer.

Most retirement savers are aware of the importance of diversification when it comes to managing your investment portfolio. Yet proper diversification is equally crucial from a tax planning perspective, as it can significantly impact your retirement savings and income over the long run.

In this blog post, we’ll explore what tax diversification is, why it matters, and how you can implement it in your retirement plan, so you can enjoy the fruits of your labor throughout your golden years.

What is Tax Diversification?

Tax diversification refers to the strategic allocation of savings and investments across accounts with different tax treatments. These include tax-deferred accounts, tax-free accounts, and taxable accounts.

  • Tax-Deferred Accounts (e.g., traditional 401(k)s and IRAs). You contribute pre-tax dollars and get a tax deduction for the amount you contribute in the year you make the contribution. The funds in these accounts then grow tax-deferred, meaning you don’t pay taxes on the investment gains each year. However, your withdrawals in retirement are taxed as ordinary income.
  • Tax-Free Accounts (e.g., Roth 401(k)s and Roth IRAs). You contribute after-tax dollars, meaning you don’t get a tax deduction in the year you make the contribution. The funds in these accounts then grow tax-free, and qualified withdrawals in retirement are also tax-free.
  • Taxable Accounts. In a taxable brokerage account, you contribute after-tax dollars and pay taxes on interest, dividends, and capital gains in the year you earn them.

Why Does Tax Diversification Matter?

Tax diversification is important for several reasons, largely because it offers the ability to create a tax-efficient income distribution strategy in retirement. By allocating your funds across different types of accounts, you can strategically withdrawal them to manage your tax bracket in retirement.

For example, traditional IRAs and 401(k)s require you to start taking required minimum distributions (RMDs) at a certain age (currently 72 or 73, depending on your birth year). Since RMDs can push you into a higher tax bracket, having funds in a Roth account, which has no RMDs, can provide more control over your taxable income.

In addition, tax rates can be unpredictable and are subject to change at any time. Having a mix of taxable, tax-deferred, and tax-free accounts can provide flexibility. It can also help you manage your tax liability as tax laws change.

Tax Diversification Strategies

Indeed, the simplest way to achieve tax diversification is to spread your retirement savings across traditional retirement accounts, Roth accounts, and taxable accounts. However, the following strategies can also help you manage your tax liability more effectively in retirement.

#1: Take Advantage of Taxable Investment Accounts

Maximizing the use of qualified accounts is a crucial aspect of sound retirement planning. However, taxable investment accounts can also play an important role in developing a tax-efficient retirement income strategy.

Taxable brokerage accounts don’t offer the same upfront tax benefits as tax-deferred or tax-free accounts. In addition, you may need to pay taxes on interest, dividends, and capital gains.

However, on the plus side, taxable investment accounts can provide a great deal of flexibility leading up to and in retirement.

For example, unlike qualified retirement accounts, taxable accounts have no contribution limits or withdrawal penalties before age 59½. That means you can invest as much as you want and access your funds when you need them without penalty.

In addition, long-term capital gains in taxable accounts are often taxed at lower rates than ordinary income. Thus, taxable accounts can complement your traditional retirement accounts by adding a tax-efficient source of income in retirement.

#2: Consider a Roth Conversion in Down Markets and Lower Income Years

A Roth conversion involves converting funds from a traditional IRA to a Roth IRA. For some pre-retirees and retirees, this can be a powerful strategy for achieving tax diversification and lowering your lifetime tax bill.

When you convert funds to a Roth IRA, you’ll have to pay income taxes on the amount you convert in the year of the conversion. However, once those funds are in the Roth IRA, they grow tax-free, and qualified withdrawals in retirement are also tax-free.

In addition, Roth IRAs have no RMDs. That means you’ll have more flexibility in retirement to tailor your withdrawal strategy to your tax objectives.

A Roth conversion can be particularly beneficial in below-average income years or down-market years. Since you pay taxes in the year you make the conversion, being in a lower tax bracket or converting a smaller balance can reduce your tax liability.

It’s important to note that Roth conversions are complex tax planning strategies and may not make sense for everyone. Be sure to consult a fee-only financial planner or tax expert if you’re considering a Roth conversion for tax diversification purposes.

#3: Tax-Efficient Investment Selection and Asset Location

You can also achieve tax diversification by deciding where you hold different types of investments based on their tax efficiency. With a tax-smart asset location strategy, you can potentially increase your after-tax investment returns and further optimize your retirement savings.

Broadly speaking, investments tend to fall into one of two categories:

  • Tax-Efficient Investments. These are investments that generate little to no taxable income, including index funds, ETFs, and tax-managed funds that have low turnover and therefore generate fewer capital gains. Any investments you hold for longer than a year may also fall into this category since they qualify for the lower long-term capital gains tax rate.
  • Tax-Inefficient Investments. These are investments that generate meaningful taxable income. Examples include taxable bonds, actively managed funds with high turnover, REITs, and high-dividend stocks. Investments you plan to hold for less than a year also fall into this category.

By strategically locating tax-efficient and tax-inefficient investments across different account types, you can minimize your overall tax burden. Here’s how a tax-efficient asset location strategy typically works in practice:

  • Hold tax-inefficient investments in tax-advantaged accounts. Since qualified accounts allow your investments to grow tax-deferred or tax-free, it can be beneficial to hold tax-inefficient investments in these accounts. That way, you can avoid paying taxes on the income and capital gains these investments generate until you make withdrawals in retirement or altogether.
  • Hold tax-efficient investments in taxable accounts. Similarly, it makes more sense to hold tax-efficient investments in taxable accounts. Since these investments generate little to no taxable income, they usually don’t result in a significant tax bill each year. Plus, when you sell these investments, you may qualify for the lower long-term capital gains tax rate if you’ve held them for more than a year.

Milestone Asset Management Group Can Help You Maximize Your Retirement Resources

According to a recent Bankrate report, 55% of American workers feel they’re behind on saving for retirement. With the average retirement lasting 18 years and possibly lasting much longer, it’s crucial to optimize every aspect of your retirement plan.

Effective tax diversification can help you manage your tax burden more efficiently, add flexibility to your retirement income strategy, and potentially extend the life of your savings. However, the right approach depends on your unique financial circumstances, including your income, tax situation, and retirement goals.

At Milestone Asset Management Group, we understand the ins and outs of tax diversification and can help you develop a comprehensive financial plan that’s aligned with your goals. To learn more about how we can help you make the most of your financial resources, please schedule a call.