A guide to tax diversification and efficient investing

When you think of diversification, the first thing that comes to mind might be a mix of stocks, bonds and cash to lower your investment risk. But if you’re saving for retirement, you’ll want to know about tax diversification as well.

What is tax diversification?

Tax diversification is when you have a variety of investment accounts that have different tax treatments: fully taxable, tax-advantaged and tax-free. Using all three types of investment accounts, you can lower your taxable income now and give you more income flexibility during retirement.

Tax-advantaged, tax free and taxable investment accounts explained

Let’s look at the three main types of investment accounts.

Tax-advantaged investment accounts

Tax-advantaged retirement accounts (also called tax-deferred accounts) include 401(k)s, 403(b)s and traditional IRAs. 

• You fund accounts with pre-tax, tax-deductible or after-tax money.
• Earnings are tax-deferred, which means you don’t pay taxes on them until you withdraw them.
• You must start taking required minimum distributions (RMDs) each year at age 73.
• Withdrawals and RMDs are taxed as ordinary income, which depends on your tax bracket.
• You may pay a 10% penalty if you withdraw money before age 59½.

If you don’t have access to an employer-sponsored plan like a 401(k) or 403(b), a traditional IRA offers similar tax benefits but has lower contribution limits.

Traditional IRAs, 401(k)s and 403(b)s can help lower your taxable income today. But they offer less flexibility in retirement due to RMDs, which could push you into a higher tax bracket.

Tax-free investment accounts

This category includes Roth IRAs and Roth 401(k)s. It also includes 529 college savings plans and health savings accounts (HSAs).

• You fund most tax-free accounts with after-tax money.
• You can fund an HSA with pre-tax money if you have a high-deductible health plan.
• Earnings are generally tax-deferred.
• Roth withdrawals are usually tax-free after age 59½ if you’ve held the account long enough. Early withdrawals on earnings may face taxes and a penalty.
• HSA and 529 withdrawals are only tax-free if used for qualified medical or education expenses, respectively.
• Roth accounts don’t require minimum withdrawals.

The benefits of Roth accounts generally kick in when you retire. Since withdrawals are tax-free after 59½, you could pay less tax overall during your retirement years.

Fully taxable investment accounts

A traditional brokerage account (generally comprised of stocks, bonds and mutual funds) is fully taxable. Other accounts, such as bank savings accounts and certificates of deposit (CDs), are also fully taxable.

Here’s what to expect from fully taxable accounts:

• You fund the account with money you’ve already paid taxes on (or after-tax money).
• You pay taxes on yearly earnings like dividends and interest. You also pay capital gains tax when you sell assets that went up in value.
• With mutual funds, you owe taxes on capital gain distributions each year.
• Your tax rate depends on your income tax bracket, how long you held an investment before it sold and whether dividends are considered qualified or non-qualified. 
• You may be able to use investment losses to lower your tax bill (this is known as tax loss harvesting).
• Beneficiaries may get a tax break, namely a step-up in cost basis for the specific assets you hold, after you pass away.

While fully taxable investment accounts offer few immediate tax benefits, they’re the most flexible in terms of use and withdrawals. They’re a good option if you’ve maxed out contributions to your retirement accounts and want to continue investing.

How tax diversification creates tax-efficient retirement income

The biggest perk of a tax-diversified investment portfolio is that it gives you more flexibility in retirement.

For example, imagine you need $20,000 in income. If you take it all from a 401(k), you have to pay income tax. If your tax rate is 20%, you need to withdraw $25,000 to meet your income need.

If you also have a Roth IRA, you have more options. You could take $10,000 from your 401(k (leaving you $8,000 after tax) and $12,000 tax-free from the Roth IRA. You get $20,000 but only withdraw $22,000 total. That saves you $3,000.

Tax diversification also helps you adapt to changing tax rates. In years when taxes are higher, for example, you can withdraw more from your tax-free Roth IRA. And in years when your tax rate is lower, you can withdraw more from your taxable accounts.

When it comes to lowering your taxes over a lifetime, awareness is key. Choosing the right account for your life stage helps you keep more of what you save. Talk with a financial professional and tax advisor to build tax diversification into your financial plan.

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