A guide to tax diversification and investing

February 09, 2021

Using a variety of investment accounts may help reduce the taxes you pay over your lifetime.

 

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.

 

Tax-advantaged investment accounts


Retirement accounts such as 401(k)s, 403(b)s and traditional IRAs are considered tax-advantaged (also called tax-deferred).

  • Accounts are funded with pre-tax or tax-deductible contributions.
  • Earnings are tax-deferred.
  • You’re required to take annual minimum distributions (RMDs) beginning at age 72.
  • Withdrawals and RMDs are taxed as ordinary income, which depends on your tax bracket.
  • Withdrawals made before age 59½ may face an additional 10% penalty tax.
     

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.

 

Fully taxable investment accounts


A traditional brokerage account (generally comprised of stocks and bonds) is fully taxable.

  • Account is funded with after-tax money.
  • You pay taxes on yearly dividends and interest earnings, as well as capital gains when you sell any stocks.
  • The tax amount depends on your tax bracket, how long you held an investment before it’s sold (in the case of stocks) and whether dividends are considered qualified or non-qualified. 
  • You may be able to deduct investment losses, subject to certain tax rules.
  • Not subject to RMDs.
     

While a traditional brokerage account doesn’t offer tax benefits, it’s the most flexible in terms of uses and withdrawals. It’s a good addition if you’ve maxed out contributions to your retirement accounts and want to continue investing for retirement.

 

Tax-free investment accounts


This category includes Roth IRAs and Roth 401(k)s, as well as 529 savings plans and Health Savings Accounts (HSAs).

  • Most tax-free investment accounts are funded with after-tax money.
  • An HSA can be funded with tax-deductible contributions or pre-tax income if you have a high-deductible health plan through your employer.
  • Earnings are generally tax-deferred.
  • Roth IRA or Roth 401(k) distributions are usually tax free, if distributions are taken after age 59½ and the Roth accounts are at least 5 years old. You’re taxed on earnings if withdrawals are made before age 59½; a 10% penalty tax may also apply.
  • HSA and 529 withdrawals are only tax-free if the money is used on qualified medical or education expenses, respectively.
  • Not subject to RMDs.
     

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.

 

Read more about the difference between IRAs and 401(k)s, or get more details on the impact of taxes on your investment returns

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