Tax Diversification: An Untapped Resource for Wealth

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published 8 September 2017

Conventional wisdom recommends diversifying investment holdings so that when one sector or asset class dips, another can make up the difference. And, for the average individual, diversification has always focused on equities, and equities alone.

That’s a problem.

Holistically, diversification is a broader process designed to mitigate risk in a variety of areas. It’s true that investors never want to own too much of one company or one sector. But it’s also true that investors don’t want to own too many assets that are taxed the same way or at the same time. This accentuates the significance of tax diversification. In my experience, it’s one of the most underrated financial planning concepts.

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Taxed Always: Holdings for which you’re required to pay income taxes annually, such as investment brokerage accounts (or even checking accounts), which may produce interest, dividends, realized capital gains and/or capital gains distributions.
Taxed Later (Deferred): Holdings for which you’re only required to pay taxes upon withdrawal/distribution — like a 401(k) or 403(b) — or when any capital gain is realized, like many forms of real estate or other hard assets.
Taxed Rarely*: Holdings for which you’re rarely, if ever, required to pay income taxes, like a Roth IRA, interest from municipal bonds and certain types of specially designed life insurance.

Most Americans accumulate the lion’s share of their wealth leading up to retirement in the first two categories. According to recent Census data, nearly half of an individual’s net worth comes from the equity in their home — which falls into the Taxed Later category, because they would only be taxed after they sell the home — and a 401(k) account. In the same Census study, less than 3% of an individual’s net worth was associated with accounts that would rarely be taxed. Americans are largely uninformed or under-informed about the principles of the Taxed Rarely category, even though it plays a critical role in effective tax diversification.

What they don’t seem to fully understand along the way is the impact that those contributions have on retirement. Overall, many individuals think or expect that, regardless of their saving behavior, they’ll be in a lower tax bracket during retirement. However, every dollar withdrawn from a 401(k) or similar plan during retirement is considered ordinary income — the same as if it were coming from your monthly paycheck while you were still working. As a result, it’s subject to ordinary income tax. Individuals who contribute the maximum to their 401(k) may receive some present tax benefit by saving pre-tax income, but they may also unintentionally push themselves into a higher tax bracket than they were expecting during retirement.**

To be clear, individuals shouldn’t avoid Taxed Later (Deferred) accounts, like a 401(k), altogether. These accounts are incredibly valuable retirement savings tools. In any plan where the employer matches contributions up to a certain point, individuals should save up to that point at least. However, investing over that maximum match level isn’t necessarily the best strategy, because it can create an even bigger pool of taxable money during retirement.

Think about it: What do you do on an average Saturday? Are you more likely to be saving money or spending it? Most individuals are more likely to spend money on a Saturday. The same holds true throughout retirement, which is why it’s surprising that many soon-to-be retirees believe that they will spend significantly less during retirement. It’s entirely possible that an individual’s standard and cost of living will actually increase during retirement, when they are likely to travel more. With that in mind, very few people can accurately forecast that they have all the money they will need for retirement.

Tax diversification is one way to save more money in the long-term, so individuals can move closer to achieving their goals without drastically changing their investing strategy. Plans that are taxed later create tax savings in the current year, the year in which an investor actually contributes to the plan. Diversified tax strategies spread those tax savings throughout a person’s lifetime, allowing for more total savings over a longer period of time.

Like the stock market, tax-planning considerations change over time. Tax code and tax policies can and do change. For example, based on historical data over the last decade, the top marginal tax rate changes on average every three years — even though it hasn’t moved much recently. Additionally, an individual’s financial situation will undoubtedly change over time as their careers and personal lives evolve. Both the current tax landscape and an individual’s current financial situation largely inform how to approach tax diversification. Which means, like any equities portfolio, individuals need to adjust their tax diversification strategy over time. Tax diversification isn’t a “set and forget” plan; it requires careful and consistent analysis to determine whether any new circumstances warrant a change in tax diversification.

One of the questions we get most often when discussing how to fold tax diversification into your overall financial plan is: What is the ideal mix of Taxed Always, Taxed Later (Deferred) and Taxed Rarely? Like so many things, there is no right answer for everyone. The ideal mix relates to your goals and milestones. It requires a personalized, tailored plan using sophisticated projections. All three categories accomplish slightly different things when it comes to tax diversification, and all can be utilized in different tax environments.

* “Taxed Rarely” refers exclusively to federal income taxes. Tax laws vary from state to state and you should consult a tax adviser on your individual state treatment of these instruments. Some life insurance contracts can be federally taxed if not structured (Modified Endowment Contracts) or surrendered correctly. Structuring the right exit strategy is imperative to ensuring the tax preferential treatment of these contracts. Proceeds from a life insurance policy are generally tax free as per section 7702 of the U.S. tax code. Roth IRA accounts have provisions that require the account to be in Roth status for five years in order to be maintain the tax preferential treatment. Some other circumstances not listed may cause these holdings to be taxed.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Building Wealth

Phil Simonides, CFP®, is Senior Vice President at www.mcadamfa.com, where he oversees the firm's Washington, D.C. metro, Chicago, Boston and central New Jersey offices. As a member of the executive team, Simonides serves as the Chair of Advanced Planning at the firm, specializing in strategies for high net worth individuals and families, and business owners. He joined McAdam in 2011 after having spent the majority of his 29-year career at Ameriprise Financial.