You know it’s important to diversify your investments across stocks and bonds to reduce risk. But did you know you can also diversify your investments for more tax-efficient investing?
When it comes to investing, tax diversification makes use of a variety of investment accounts with different tax treatments – tax-advantaged, fully taxable and tax-free. A strategic use of all three can help you lower your taxes now and into retirement.
Retirement accounts such as 401(k)s, 403(b)s and traditional IRAs are considered tax-advantaged (also called tax-deferred).
Traditional retirement accounts like a 401(k) or 403(b) are popular as they’re often an employer-offered benefit. Many employers even match contributions, up to a certain amount. If you don’t have access to an employer-sponsored plan, a traditional IRA provides the same tax benefits (although there are different contribution limits).
These types of retirement accounts can help reduce your taxable income today but due to RMDs, can also move you into a higher tax bracket in retirement.
A traditional brokerage account (generally comprised of stocks and bonds) is fully taxable.
This category includes Roth IRAs and Roth 401(k)s, as well as 529 savings plans and Health Savings Accounts (HSAs).
The benefits of Roth accounts generally arrive as you near retirement. For example, since withdrawals from a Roth account are tax-free after age 59½, you could pay less income tax in the long run throughout retirement.
When it comes to lowering your taxes over a lifetime, awareness is key. Understanding when and how to choose the right investment account for your needs and life stage can help you minimize your tax bill and maximize your savings.