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Tax Diversification

Most know of the benefits of diversifying their investment dollars; i.e., spreading one’s investment dollars among different types of assets, but benefits can also be realized by diversifying how those assets will eventually be taxed.  Granted, most will have the largest portion of their retirement dollars in tax-deferred accounts like 401ks and IRAs, but tax diversification and being aware of which accounts are best for which types of assets can also prove beneficial if one has the opportunity to use other types of accounts. 

Our savings/investment accounts will eventually be taxed in one of three ways.  Let’s look at each one.

Some accounts will be taxed as regular income.  Traditional IRAs as well as 401ks and 403bs are “tax-deferred.”  This money was not taxed prior to it being deposited into these accounts; thus it will be taxed as regular income when it is withdrawn.  Although these accounts have grown tax free while we were working and contributing to them, the tax man was looking over our shoulders as we checked the balances, rubbing his hands in anticipation of the day we begin withdrawals.  We forego the benefits of having some of this money taxed as dividends or capital gains (which have traditionally been taxed at a lower rate) for the opportunity of allowing it to grow tax-free for years.  This same issue faces those who own deferred annuities as they can also turn capital gains and dividends into “ordinary income.”

ROTH accounts are really “special creatures.”  They come as IRAs, and more and more companies are offering 401ks as ROTHs.  The money that goes into these accounts is “after tax” money, and under current tax law that money, along with any earnings, can be withdrawn tax free once the owner is 59 ½, and the account has been open for at least 5 years.  The original investment in an IRA can be withdrawn any time with no penalty or tax, regardless of age.  A Roth account offers a wonderful savings opportunity, but not everyone will qualify for one.  Check the income rules for opening one and if you qualify, open one post haste if you can possibly afford to do so! 

Regular taxable accounts, like the brokerage account or mutual fund you may own outside of a tax-sheltered plan, also have tax advantages.  When you sell from these accounts you are allowed to exclude your basis (your original investment) from taxation since this money was previously taxed.  Also, any capital gain you may realize when you sell is presently taxed at a lower rate than ordinary income.  Likewise, the dividends you may have received have also been treated with a favorable tax rate.  There is much to recommend taxable accounts, and they are great accounts for individual, dividend paying stocks where you can realize the benefits of the lower tax rate on dividends and capital gains.

Traditional IRA’s and 401k’s are great retirement savings tools, and I would encourage most to max out their opportunities with these accounts.  These accounts are a good place, tax wise, to hold some of the bond allocation of your total portfolio.  However, if you qualify for ROTH accounts, you will certainly want to investigate that opportunity after ensuring that you defer enough to your 401k to get your employer match, if it is offered.  The advantages of a ROTH account are sizable, especially if you have years remaining before you will be withdrawing from the account.  They are an especially appropriate place for small cap stocks and funds that can be left to grow for years.  Imagine if you had bought 500 shares of Apple stock in a ROTH account 20 years ago at $7.20 per share.  You would now have an account worth nearly $300,000 available to you tax free in retirement! 

Each of the accounts I have mentioned have their unique tax characteristics and each offers some tax advantage.  Being aware of their differences and how certain asset classes better fit certain accounts can make a difference in your eventual post tax return.  But of much more importance is how well we relate to the idea of “deferred gratification,” and exactly how much we save in some account along the way.  And please remember, though far from the most important thing, still, money matters.


Fly/Drive Safely

1 June 2014




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Reader Comments (1)

Many current retirees simply haven't had the availability of Roth IRAs to them, because either their income fell outside the Roth criteria or because Roth IRAs are a more recent development (compared with the length of time we've had traditional IRAs). Also, if one received a lump-sum pension payout, it didn't make much sense to put it into a Roth and incur a huge tax liability in the process. Nonetheless, tax diversification is a good strategy if you are able to pull it off in a way that makes sense.

December 5, 2014 | Unregistered CommenterDave

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