Tax Diversification – How Does It Impact You?
Tax diversification is a very important topic that often gets overlooked because many people don’t truly understand what tax diversification means. So, what is tax diversification, why is it important, and what does it mean to you and your family?
Tax Diversification
While you can never eliminate taxes altogether, there are tax-efficient strategies you need to be aware of. It’s critical that you understand the different types of buckets that money can be invested in, how that impacts you now, and how that impacts you in the future; when you have to start withdrawing from some of these investments to support your income, and retirement, or lifestyle.
You may be aware of what it means to be diversified within investments, such as different stocks, bonds, mutual funds, different sectors, international, and more. There is also diversification in our income streams in retirement, such as Social Security, potentially a pension, rental income, dividends, interest, and annuities. These are all different ways that we can diversify our income to try and provide as much sustainable, reliable, and predictable income as possible through our retirement.
There are three buckets of tax diversification, and you may have investments in all of these buckets or maybe just in one.
Taxed Always Bucket
Taxed always means investments that provide 1099s, regular 1099s, CDs, or dividends. Essentially, regular money like brokerage accounts or non-retirement accounts, not including IRAs, Roth accounts, or 401ks. Investments in standard brokerage accounts incur taxes on dividends, interest income, and capital gains in the year they are received or realized. You will always be taxed on these accounts. Every year, as dividends and capital gains are paid, you will pay taxes on those accounts as you go along.
Tax-Deferred Bucket
The taxed later bucket includes things like regular or traditional 401ks, individual retirement accounts, and pre-taxed money. Any money that you invest into these accounts is pre-taxed. Many people get excited about these pre-taxed accounts because it saves them a little money on their tax returns. But what a lot of people don’t realize is that you may save a little money today, but when you defer taxes for ten, twenty, thirty, and sometimes forty years, as that money potentially grows, you now owe taxes on a much larger investment amount. It’s a sort of save now and pay later situation.
Investments in accounts like 401(k)s and traditional IRAs grow tax-free until withdrawals begin, at which point they are taxed as ordinary income, which is subject to tax when you use it as income in retirement and have to take RMD’s.
Tax-Exempt Bucket
The tax-exempt, taxed seldom or sometimes called taxed never, or tax-free bucket probably gets overlooked the most regarding investments. These are going to be things like Roth IRAs, Roth 401ks, and other similar investments, where essentially you pay tax on the money today in your working years. As the money grows over time, and when you go to pull the money out, all of it is tax-free to you and your family down the road. So you pay today to save later.
Contributions to accounts such as Roth IRAs and 529 college savings plans are made with after-tax dollars, but earnings and withdrawals are tax-free, provided certain conditions are met.
If you believe that taxes will either stay the same or potentially go up, would it make sense to pay taxes on money today, and over time, never pay tax on that money again, regardless of what it grows to? So if you believe your investments are going to grow over time, and hopefully you do, you may want to consider having more in that taxed seldom bucket. Pay taxes today, again, to save later in the future.
Tax Opportunities
Now, as you can probably imagine, there are some tax consequences and considerations that need to be made when looking at which bucket will be the most appropriate for you and your family. Do you know where you stand currently with your tax diversification? Do you know what opportunities exist to help minimize, limit, or reduce taxes on your income and investments in the future?
You can look into this for yourself is to reach out to your own financial advisor, or if you don’t have one or just want a free second opinion, we’d be happy to talk with you.
A defensive tax strategy could save you a SIGNIFICANTLY in retirement. If are unsure what your tax strategy looks like, we highly recommend you take advantage of our FREE, Retirement Tax-Savings Analysis.
Not sure you need the analysis yet? Just schedule a 15 minute call and we will help you figure it out.