As an investor, you will have access to accounts that are taxed differently from one another. And it’s possible you could benefit from tax diversification by owning accounts in these three categories:
Tax-deferred – Tax-deferred accounts include the traditional IRA and a 401(k) or similar employer-sponsored retirement plan. When you invest in tax-deferred vehicles, your money can grow faster than if it were placed in an account on which you paid taxes every year. You also may get a tax deduction for contributions you make today. When you start taking withdrawals from these tax-deferred accounts, typically during retirement, the money is usually taxed at your ordinary income tax rate.
Taxable – Taxable investments are those held in a standard brokerage account, outside your IRA or 401(k). While you can put virtually all types of investments into a taxable account, you may want to focus on those considered to be most tax-efficient. So, you could include individual stocks that you plan to hold, rather than actively trade, because you will not get taxed on the capital gains until you sell. You also might consider mutual funds that do little trading and generate fewer capital gain distributions. This is important not only in terms of controlling taxes, but also because the taxes on these distributions can reduce your investments’ real rate of return.
Tax-free – When you invest in a Roth IRA/Roth 401(k), you don’t get an immediate tax deduction, but your earnings, as well as your withdrawals, are tax-free, provided you do not start taking withdrawals until you’re 59 ½ and you have had your account at least five years. (However, income restrictions do apply to Roth IRAs.)
So, given the difference in how taxes are treated in these accounts, how can you choose where to put your money? For example, when would you contribute to a Roth IRA or Roth 401(k), rather than a traditional, tax-deferred IRA or 401(k)? If you are in a high tax rate now and expect it to be lower in retirement, a traditional IRA may make more sense, as you potentially get a sizable benefit from the tax deduction. But if you are in a lower tax rate now, you have most of your retirement investments in tax-deferred accounts, and/or you can afford to forego the immediate tax deduction, you might find that the Roth IRA/Roth 401(k), with its tax-free withdrawals and earnings, ultimately will make more sense for you. But since no one can predict where tax rates will go in the future, having money in different types of accounts – i.e., tax diversification – can be beneficial.
If you only focus on traditional, tax-deferred accounts, you could end up with larger tax bills than you anticipated when you retire and start tapping into these accounts, particularly when you must start taking withdrawals – called “required minimum distributions” – when you reach 70 ½. By having money in accounts with different tax treatments, you may have more flexibility in structuring your withdrawals during retirement, based on your year-to-year tax situation.
There’s no formula for achieving an ideal tax diversification. You’ll want to consider your own needs and circumstances in choosing the right mix of taxable, tax-deferred and tax-free accounts. Ultimately, taxes should not drive all your investment decisions – but they should not be ignored, either.