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Tax Diversification for Investments

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In past articles I have advocated the concept of spreading your tax-treatment out – so that you have money allocated in three major types of accounts: deferred tax (such as IRAs and 401(k) plans), tax-free (Roth IRAs), and capital gains taxable accounts. The reason behind this is that our fine government has this tendency to change the rules, and often. By spreading your tax treatment out you can help to ensure that funky new rules don’t throw off your entire retirement investing plan. In addition, having multiple modes of taxation can give you much flexibility in planning your income for tax purposes, once you get to the distribution phase of life.

The trick to all of this is to think about the timing of contributions to each kind of account… of course there are no hard and fast rules to determine what’s best for each kind of plan. Below is a discussion of some of the factors that you should consider as you balance out your tax treatment.

Early in life…

Early in your investing career it may makes a lot of sense to load as much of your savings into your 401(k) or other tax-deferred savings vehicle as possible, in order to maximize the benefit from tax savings up front. The biggest reason for this (beyond the tax savings) is so that you take advantage of your employer’s matching benefit, along with deferring taxes on your income as it increases over time.

If your tax bracket is really low though, you might want to utilize the Roth option in your 401(k) and maxing out your Roth IRA during this earliest, lowest-taxed time of life. A bit later when your tax bracket has increased somewhat, the tax reduction benefits of traditional 401(k) contributions and IRA contributions will be more valuable.

Later in your career when your income is higher, maximizing contributions to tax-deferred accounts will have a greater benefit to you from a tax savings standpoint. This is assuming that you expect for the taxes you’ll pay later during retirement will be lower due to your diversification of tax treatment.

As mentioned, as your income supports it you should begin making contributions to your Roth IRA as soon as possible.  This is partly due to the restrictions on income around investing in Roth IRAs – but mostly because you are paying tax at lower rates in your lower-earning days than you might later on in your career when your income increases.

And then on top of it all, when your income has grown to a point that you can maximize the other options (401(k) and Roth), you should begin investing in an account that is taxed by capital gains tax. This will give you the third leg of the tax-diversification stool. Since capital gains are presently taxed at a much lower rate than ordinary income – which is what your IRA or 401(k) distributions are taxed at – it makes a great deal of sense to have some of your money invested in these accounts as well.

Later in life…

Later on in your life, as you come near to that point where you will have to begin taking Required Minimum Distributions (RMDs) from your IRA and 401(k) accounts, it might make sense to take significant portions of those accounts and either convert them to Roth accounts or capital gains taxed accounts. The preference would be to place the funds distributed into a Roth IRA as a conversion, especially if you are in a position where you will not need access to the funds for some time and therefore can benefit from tax-free growth of the account. You may also want to balance those conversions to Roth with some non-tax-deferred investments as well – because you never know what may happen with the tax code. Either way, Roth conversion or distribution and re-investment in a taxable account, you’ll pay income tax when you withdraw the funds from your tax-deferral account such as a 401(k) or traditional IRA.

It’s (very!) possible, given the government’s need to increase tax revenues to pay for things like COVID giveaways, that there could be changes in the works for how tax-deferred plans are taxed. Just a few options that have been put forth in recent memory include:

  • extra taxes on IRA assets (this was in place back in the mid-80’s)
  • changes to the minimum distribution rules to require faster distribution or to eliminate “stretch” capabilities (this happened with the SECURE Act)
  • adding investment restrictions, such as requiring a portion of IRAs to be invested in “socially responsible” investments (not as likely but you just never know)
  • nationalization of retirement accounts – e.g., governmental takeover of all IRA and 401(k) plans in exchange for a superannuization plan like some socialized countries use (also somewhat unlikely but again, there’s always a however in life)

Yet another option, especially if you have very few assets outside your IRAs and 401(k) plans, you can reduce your taxable estate (when normal folks have an estate tax again, that is) by taking extra distributions from your IRA or 401(k) and making gifts to your children and grandchildren. You could place the assets in a trust that represents a completed gift, or give the money directly to your future heirs – this way you are able to see your children and grandchildren enjoying the fruits of your labors while you’re still living.

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