Taxes and Finance
Strategies & Tips, Taxes

Tax Diversification: The Benefits


Investing 101 teaches the benefits of diversifying your investments. Owning bonds helps lower portfolio volatility when stocks go on a wild ride like they did in the fourth quarter of 2018 while an alternative investment may zig when the stock market zags. But have you considered the benefits tax diversification may bring to your portfolio?

Three Buckets

Tax diversification is the idea of having assets diversified into three major buckets: pre-tax or IRA dollars, after-tax dollars, and tax-free or Roth IRA dollars. In retirement, your taxable income is typically limited to IRA withdrawals, Social Security, and pension income (if you’re lucky enough to have one). As a result, with appropriate planning, your retirement income has the potential to be much lower than during your working years. However, if all your income comes from pre-tax dollars in your workplace 401k/403b or IRA, any amounts withdrawn from these sources is taxed as if you were still working which could lead to a more substantial tax burden. If you are diversified among the three buckets, you can limit withdrawals from pre-tax accounts in favor of withdrawals from your after-tax and tax-free accounts in any given year to control the amount of income tax you pay the government.


Saving money pre-tax is generally appealing because it lowers your current taxable income in the year you make the contribution. But tax deferral is not tax exempt, meaning you are merely shifting the tax liability to some point in the future. Withdrawals are taxed at ordinary income rates (as if you were working) and as long as you’re over 59 ½, no penalty is owed. Even if you’re lucky enough not to need these funds, the government has a plan to tax them: beginning at age 70 ½ you will face mandatory withdrawals which force you to pay tax on at least a portion of these funds each year.


Funds saved in savings accounts and after-tax brokerage accounts are taxed as you go: income is taxed in the year it was earned and capital gains at the time they are realized. As such, these funds can be used without tax consequences.


Roth funds are, in our opinion, the best retirement tax diversification play. Once you attain age 59 ½, withdrawals are free of income taxes. There is no mandatory distribution either, so you ultimately have control of timing distributions. Roth IRA contributions do have an income limit but Roth conversions and contributing to a Roth 401k do not, so there are ways to fund a Roth even if you are not eligible to make annual contributions. Starting early and perhaps considering a Roth conversion has the potential to reduce reliance on pre-tax funds and the associated tax liability in retirement years.


Having funds diversified in pre-tax, after-tax, and tax-free buckets allows for tax diversification and provides the potential to lower your tax burden in retirement. This less discussed topic may be equally as important as investment diversification when it comes to retirement planning. If your savings are not currently diversified by tax source, we recommend having a conversation with your tax professional and investment advisor. Talk to us. We’d enjoy having that conversation with you.



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