Tax Diversification: An Overlooked Part of Financial Planning

Most investors know that asset diversification is an important part of financial planning, but many miss out when it comes to tax diversification because their financial advisor doesn’t focus on it. This is a missed opportunity to potentially reduce your tax burden over your lifetime and at the same time, increase your financial flexibility.

What is Tax Diversification?

Tax diversification is a financial planning technique where an investor’s savings are allocated among different types of investment accounts that have different tax treatments over time.

Different Types of Tax Treatment on Investment Accounts

Tax-Deferred: These are typically retirement accounts like 401(k), 403(b) and Traditional IRA accounts. They are generally funded with pre-tax or tax-deductible contributions and earnings grow on a tax-deferred basis until withdrawn. Starting at age 73, investors are required to take annual minimum distributions (RMDs) that are taxed as ordinary income. Overall, tax-deferred accounts help reduce your tax burden today but put you in an unknown tax bracket later in life. 

Tax-Free: This category of investment accounts include Roth IRA and Roth 401(k) accounts. They are typically funded with after-tax contributions and earnings grow on a tax-deferred basis. Distributions are usually tax-free if taken after age 59 ½ and the account is over 5 years old. Roth accounts typically benefit investors later in life as you could pay less income tax through retirement. 

Taxable:  These are traditional investment brokerage accounts that are funded with after-tax money. Investors pay taxes each year on dividends, interest earnings, and realized capital gains. While taxable investment accounts do not offer tax benefits, they are more flexible in terms of access to your money for withdrawals. 

What’s the Ideal Allocation for Tax Diversification?

Unfortunately, there isn’t a one-size-fits-all answer to this important question. The ideal allocation of assets among the different types of investment accounts depends on each investor’s personal situation (goals, timeline, assets, company 401k match, etc.). Rest assured, the team at American Portfolios Denver is well versed at incorporating “tax diversification” into our GlidePath Financial Planning Process for our clients and we’re ready to do so for you.  

Contact Us to Discuss Tax Diversification

American Portfolios Financial Services, Novem Group, American Portfolios Advisors, AP Denver, Inc., and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.