Tax season is almost over and, in the middle of the month, millions of Americans will be paying their tax bills or receiving refunds. In the world of finance and investing, the concept of diversification is often emphasized as a crucial strategy for managing risk, but there’s another facet of diversification that is equally important but often overlooked: tax diversification. What some don’t know is that, by diversifying your investments, you could pay less tax years down the line! While many investors focus solely on maximizing returns, implementing tax diversification strategies can significantly impact long-term wealth accumulation and preservation.
There are a few different ways that your investments can be taxed. Most of the time they are divided into three buckets: tax me now, tax me later, or don’t tax me at all.
- “Tax me now” are your typical brokerage accounts. You take your post-tax earnings and invest them into stocks, bonds, real estate, or private investments. Assuming you have a gain in the investment, and you hold it for at least 1 year, you will pay a capital gains tax rate when you sell it. The current rates are either 0%, 15% or 20% for long-term gains depending on your income. If you hold the investment for less than 1 year you will pay ordinary income taxes on the gain, which is typically a higher rate. You also pay taxes on the interest and dividends the investments produce. There are various nuances to tax rates and income thresholds for them, so it’s best to consult a tax advisor or financial advisor for guidance in your specific situation.
- “Tax me later” are your typical retirement accounts or deferred compensation accounts. They consist of your 401(k), Traditional IRA, and 457 plans. You put pre-tax money in them to defer your tax to a later date. There is no tax owed when you buy or sell securities within your account or when dividends or interest is paid. Tax is only owed when you distribute money from the account.
- “Don’t tax me at all” accounts are your typical Roth IRA and Roth 401(k) accounts, as well as tax-free municipal bonds. The Roth IRA has income limitations to be able to contribute to them, but the Roth 401(k) does not. In addition, there are ways to contribute to Roth IRAs through what is commonly referred to as a backdoor Roth or mega backdoor Roth. If set up properly, small business owners may be able to do large after-tax Roth conversions within their 401k or Solo-401(k) plans. (Does this line isolate readers who aren’t business owners?)… I think this is ok to leave in as one of my main targets is commercial real estate brokers that fit this model.
Preparing for retirement is one of the main reasons you should diversify your taxes. When you have your assets in various tax buckets, it gives you tremendous flexibility to lower your overall taxes once you start living off them. Since tax rates could be higher or lower in the future, it’s important to be able to pull money from various buckets to take advantage of whatever they may be. If tax rates are higher and expected to go up, you will probably want more Roth money. If capital gains taxes are lower, you’ll want to be able to strategically sell off some of your brokerage assets to take advantage of them. In almost any scenario you’ll want flexibility with investment taxes.
Also, if you’re looking to retire before age 59 ½, having money stored in a taxable account is extremely important because this will be your main source of income until you are able to tap into your retirement accounts without penalty.
In addition to having all three buckets, it’s important to note what types of investments belong in which buckets! By strategically allocating assets across these accounts, investors can potentially minimize their tax liability and maximize after-tax returns.
Putting a lot of high-yielding taxable bonds into your “tax me now” brokerage accounts typically makes little sense as all of the income that the bonds pay will be taxed at ordinary income tax rates. This rate can be north of 40% if you’re in the highest tax bracket! Instead, having those located in your tax deferred accounts may make more sense.
Conversely, look at putting low dividend/high growth paying ETF’s or stocks in your taxable brokerage accounts as you won’t pay any tax on them until they’re sold at lower capital gains tax rates.
The placement of your private investments matters as well. There are many private investments that consider early returns as “return of capital.” This means that as money is distributed in early years there could be no tax owed as the fund or investment is simply returning your initial investment to you.
Incorporating tax diversification strategies into your investment plan can enhance overall tax efficiency, potentially increasing after-tax returns and providing flexibility in retirement planning. By spreading investments across different account types and employing tax-efficient strategies, investors can mitigate tax risks and maximize wealth accumulation over the long term. Consult with a financial advisor or tax professional to craft a strategy that meets your individual financial goals.