Last week we looked at diversification of the assets that make up your investment portfolio. That’s what most folks think of when the term “diversification” is used. Think of it as your “investment recipe” and trying to get all the ingredients in there in all the right proportions.
But though less-often discussed, no less important is diversifying the tax treatment of your investments.
So once you have a general idea of the way you wish to position and diversify your assets, you need to determine where you want them to reside.
For the sake of simplicity, here are the four basic types of accounts available to most individuals. Your situation will vary, so only use the following as a guide.
(1) Tax deductible / deferred accounts. These are generally referred to as retirement accounts. In a tax deductible / tax deferred account, contributions are made to the account with dollars that have not yet been taxed.
Your funds grow tax deferred while remaining in the account, and you will owe income taxes at whatever your particular tax rate is upon withdrawal at your retirement age.
Some individuals may find themselves in a lower tax bracket in retirement, but that should not be assumed. Individual circumstances will vary.
(2) Tax free accounts. Contributions are made post-tax (no deduction in the year of contribution). But the funds grow tax free while in the account. And if the funds remain in the account until the account holder is age 59 ½ or for five years (whichever period is longer), the funds may be withdrawn income tax free.
(3) Tax deferred accounts. Some individuals do not qualify for individual retirement accounts, either traditional or Roth. The IRS has income limits.
In these cases, contributions may be made to an IRA on a non-tax deductible basis so that funds may grow tax deferred. Income taxes will still be owed on the growth upon distribution.
(4) Taxable accounts. These are simply investment accounts offering no special tax treatment. Contributions to such accounts are unlimited, but offer no special deductions for making the contribution.
A word about income taxes. Will income taxes be higher or lower in your future? No one knows for sure. This fundamental uncertainty about one’s future tax liability would seem to argue for a diversification in tax strategies as well. Combining one’s use of tax deductible, tax free, tax deferred and taxable accounts may be worth considering.
The future is unknowable. So not having all your “investment eggs” or “tax eggs” in one basket just seems to make sense.
That’s the essence of diversification.
