Definition of Tax Diversification
Tax diversification, in relation to investment, refers to spreading assets across multiple investment accounts that are subject to varying taxes. For example, tax diversification can help an investor decide whether to use a Roth IRA or a traditional retirement account. It can assist investors in determining when to use a regular brokerage account instead of a retirement account. The best application of tax diversification may require using all three types of accounts.
Tax Diversification: 401(k) vs. Traditional Retirement Account vs. Roth IRA
Many investors wonder which is better: a 401(k), a traditional retirement account, or a Roth IRA. You may want to have a mix of all three. The general rule of smart personal finance is to always contribute enough to your 401(k) to get the employer match. If you can save more for retirement, invest that amount in a Roth IRA.
When choosing between traditional contributions (pre-tax) and Roth contributions (after-tax), the general rule is to use a traditional retirement account or traditional 401(k) if you expect to be in a lower tax bracket at retirement. If you anticipate being in a higher tax bracket at retirement, use a Roth IRA. If you’re in the same tax bracket at retirement as you were when making contributions, the benefits of traditional and Roth retirement accounts are equal.
The challenge in choosing between traditional accounts and Roth IRAs is that there’s no way to accurately predict what tax rates will be in 10, 20, or 30 years. For this reason, it might be smart to maintain both types of retirement accounts. Remember that employer matching contributions are always made on a pre-tax basis.
Similarly, it may make sense to have a regular brokerage account in addition to your retirement accounts because of the taxes. All qualified retirement accounts grow on a tax-deferred basis, and withdrawals are taxed as ordinary income. However, withdrawals from taxable accounts (from selling securities like stocks or mutual funds) are taxed at capital gains rates. Roth IRAs differ slightly, as contributions are made after tax, and qualified withdrawals are completely tax-free.
If you wish to retire before becoming eligible for the full benefits of social security, it may be wise to have accounts where withdrawals are taxed at a lower rate (or not taxed at all) during those critical early years of retirement.
Benefits of Tax Diversification
As you may have already guessed, the benefits of tax diversification (spreading savings across different account types) are similar to those provided by diversification in investing – they reduce risk. For example, most people pay a long-term capital gains tax rate of 15% for investments in taxable accounts (although the precise rate will depend on your income level). For retirees who withdraw at least $40,526 throughout the 2021 tax year ($81,051 for married couples filing jointly), the tax rate in this bracket will be at least 22%.
You will get the most benefit from tax deferral by leaving 401(k) and traditional retirement funds untouched and allowing them to grow tax-free for as long as possible. Therefore, it is wise to withdraw funds from taxable accounts and Roth IRAs first in retirement and withdraw from tax-deferred accounts later.
Conclusion
Not
One can only speculate on what tax laws will do, especially contracts in the future. Investors need to carefully consider potential tax scenarios during retirement before making long-term decisions about what types of accounts to invest in. For example, it is wise to consider the possibility of being in a higher or lower tax bracket during retirement and to invest accordingly.
If you are unsure of the tax bracket you will be in during retirement, it may be wise to have assets spread across different types of accounts, such as a traditional retirement account or 401(k) or a Roth IRA.
Resources
The Balance only uses high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and quality of our content.
Source: Internal Revenue Service. “Individual Retirement Arrangements (IRAs).” Internal Revenue Service. “401(k) Plan Overview.” Internal Revenue Service. “Traditional and Roth IRAs.” Internal Revenue Service. “Topic No. 409 Capital Gains and Losses.” Tax Foundation. “2021 Tax Brackets.”
Source: https://www.thebalancemoney.com/tax-diversification-with-investing-2466705
Leave a Reply