The Importance of Tax Diversification

Diversification is a key concept in investing. By diversifying your investments, you can reduce your risk and improve your chances of achieving your financial goals. But did you know that you can also diversify your investments for tax purposes?

Tax diversification is the practice of investing in a variety of accounts with different tax treatments. By doing this, you can reduce your overall tax bill and improve your after-tax returns.

There are three main types of tax-advantaged accounts:

• Tax-deferred accounts allow you to avoid tax today on money going in and pay tax when you take the money out. Everything you put into these accounts is a tax deduction in the year you contribute. This can be a great way to save money on taxes, especially if you are in a high tax bracket now. Some examples of tax-deferred accounts include traditional IRAs, 401(k) plans, and 403(b) plans.
• Tax-free accounts are taxed when you put money in and avoid tax when you take money out. You do not receive a tax deduction but the funds grow tax free. Some examples of tax-free accounts include Roth IRAs, Roth 401(k) plans, HSAs, and 529 plans.
• After-tax accounts are not tax-advantaged, but they offer the most flexibility in terms of how you can use the money. You can withdraw the money at any time, for any reason, without any penalties. However, you will owe taxes on any gains or any income you earn. Some examples of after-tax accounts include taxable brokerage accounts and UTMA/UGMA accounts.

The best way to determine what is right for you is to speak with a financial advisor. They can help you assess your individual financial situation and create a tax diversification strategy that meets your needs.

Here are some of the benefits of tax diversification:

• Reduce your overall tax bill. By investing in a variety of accounts with different tax treatments, you can reduce your overall tax bill. For example, if you are in a high tax bracket now, you may want to contribute to a tax-deferred account, such as a traditional IRA or 401(k) plan. This will allow you to defer taxes on your investment gains until you withdraw the money in retirement, when you may be in a lower tax bracket.
• Improve your after-tax returns. Tax diversification can also help you improve your after-tax returns. For example, if you invest in a tax-free account, such as a Roth IRA, you will not have to pay taxes on your investment gains when you withdraw the money. This can lead to higher after-tax returns, especially if you are in a high tax bracket.
• Increase your flexibility. Life events can change your savings and income needs in the future. Diversifying your savings into accounts with different tax treatment will give you greater flexibility to adapt to both planned and unexpected life events.

To learn more about tax diversification and how it can help save you money on taxes, please reach out to schedule a free consultation.

Disclaimers / Sources:

Stock investing includes risks, including fluctuating prices and loss or principal. This information is not intended to provide specific advice or recommendations about any stock nor is it intended to be a recommendation to buy, sell or hold any stock investment. We suggest speaking with your financial professional about your situation prior to investing.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.