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What’s Tax Diversification and Why is It Important

May 08, 2015

We are all familiar with the concept and importance of investment diversification and asset allocation. But tax diversification is likewise essential. If you could invest in a “tax perfect” retirement account or plan, what would it look like? It would probably include:

  1. Contributions that are Tax-Deductible
  2. Accumulation that is Tax Deferred
  3. Distributions that are Tax-Free

Unfortunately, we can’t have all three at once. But, fortunately, using a variety of strategies, you can have 1 and 2 or 2 and 3. Let’s find out how…

The concept is that we don’t want all of your assets subject to the same tax risks.

Most people have the majority of their retirement savings in pre-tax accounts, such as 403(b)s, 401(k)s, TSAs, 457 Deferred Comp, Traditional IRAs and SEP/IRAs. These vehicles offer tremendous tax advantages in the accumulation phase, but when you are ready to use the funds, they can create a tax nightmare.

Not only will you pay tax on the funds you or your employer contributed, but you will also pay tax on the accumulated earnings as they are withdrawn at your highest marginal tax rate at the time – plus that added income may cause more of your Social Security income to be taxed!

With the economic problems facing the country, where do you think tax rates are going? We don’t know when, but with an $18 Trillion Federal deficit, taxes will likely go up some time in the future. So doesn’t it make sense to have at least some of your money in the tax free bucket?

Many like the idea of paying taxes now on savings for retirement, knowing they will not have to pay taxes on the growth or distribution of that savings and current tax rates are likely lower than future tax rates. The most common financial vehicles to accomplish this are a Roth IRA, Roth 403(b), Roth 401(k), Roth 457 Deferred Comp and tax-free municipal bonds.

But there are some lesser known tax strategies, such as the tax-free capital gains exclusion on the sale of your home. This example gives you an idea of how it works:

Mary and John purchased their home many years ago for $150,000 and it has since been paid off. Their house had grown in value to $300,000. So they opted to sell it and move into a smaller home, which they purchased for $150,000. Using the tax-free capital gains exclusion, they added all $150,000 in appreciation to their retirement savings tax-free.

There’s a very applicable quote by Benjamin Franklin for this month, “There are only two things certain in life: death and taxes.”

So, instead of having all of your money in the taxable bucket, doesn’t it just make sense to have some money in the tax free bucket? This tax diversification gives you more flexibility to weather any taxable environment.