Contributed by: Caleb Christian CFP®, CLU®, ChFC®

“In this world, nothing is certain except death and taxes.” This famous quote from Benjamin Franklin emphasizes an often-overlooked aspect of investing: tax diversification. While many investors focus on traditional diversification strategies—spreading their assets across various stocks, bonds, and asset classes—it’s equally important to consider ways to diversify tax exposure.

Understanding Tax Diversification

Though tax diversification may seem daunting at first, it can be distilled into three essential concepts. First, it's vital to understand that paying taxes in retirement is "voluntary." The taxes investors owe in the future are significantly influenced by the investment decisions they make today. For example, think about two individuals: one has $2 million in a Traditional IRA which would be taxable upon distribution, while the other holds the same amount in a Roth IRA which can be potentially tax-free upon distribution. Which person truly has more wealth?

It’s also crucial to assess the balance in your traditional 401(k). Many investors focus only on the gross amount, overlooking the net value after accounting for taxes and penalties, if applicable. A clear understanding of your tax liabilities can transform how you view your investment portfolio.

Defining Tax Categories

Investments can be categorized into three distinct types based on their tax implications: Pre-Tax, Taxable, and Tax-Free.

• Pre-Tax Assets: These investments provide a tax deduction in the year the contribution is made. Taxes on these assets are deferred until withdrawal, offering immediate tax benefits, but deferring the tax liability to a future date.
• Taxable Assets: These investments, funded with after-tax dollars, may be subject to annual taxation, and incur taxes when assets are disposed of, underscoring the need for strategic planning, and tax-efficient asset allocation during the accumulation phase.
• Tax-Free Assets: Funded with after-tax dollars, these assets generally grow tax-deferred, and allow for tax-free withdrawals in the future if structured properly and certain provisions are met, providing advantages for investors seeking to optimize their long-term tax efficiency.

Recognizing these distinctions is critical for informed investment decisions, as each category carries unique implications that can significantly affect your overall financial strategy.

Exploring Hypothetical Scenarios

Consider a scenario where you have $3 million in your Pre-Tax 401(k). Many clients have considered an alternative for a more tax-diversified approach as follows:

• $1 million in your pre-tax 401(k)
• $1 million in a taxable brokerage account
• $1 million in tax-free accounts

This strategic allocation fosters genuine tax diversity and enhances your ability to manage tax brackets effectively during distributions—whether they occur pre-retirement, in retirement, or through estate transfer. Such a comprehensive approach not only optimizes financial planning but also equips investors with the tools to navigate the complexities of tax implications confidently.

Addressing Current Income Concerns

Some may argue, “I need deductions now. My tax burden will surely be lower in retirement.” However, it’s important to remember that tax brackets can change over time. For instance, if your current taxable income is $200,000 with an average tax burden of 20%, that could result in $40,000 in annual taxes. Your income might drop to $100,000 in retirement, but if the average tax burden also rises to 40% through legislative changes, you would still owe $40,000 in taxes, despite earning half the income. Additionally, the impact of large Required Minimum Distributions (RMDs) may involuntarily force you into a higher tax bracket later in life if not managed correctly.

Strategies After the Accumulation Phase

If you find yourself in retirement currently, there can still be effective strategies to consider. Working with financial and tax professionals can reveal options such as converting portions of your Traditional IRA to a Roth IRA, utilizing a ‘substantially equal periodic payments’ (SEPP) option for those below the penalty-free withdrawal age in qualified accounts, or developing a strategic gifting and wealth transfer plans. Additionally, considering tax-loss harvesting for taxable accounts can have a positive impact. Finally, consider effective asset "location" strategies which refer to owning the appropriate assets in the appropriate tax classifications.

In conclusion, tax diversification is a powerful strategy that can significantly impact investors net returns and how much of their wealth they actually get to "keep." By creating a tax-diversified portfolio, investors can gain greater control over their financial future, effectively managing tax liabilities to maximize wealth and secure a comfortable retirement. A helpful tool for to quickly visualize tax diversification is this handout on Tax Efficient Funnels, which can be found by Clicking Here. For more information or to discuss your unique circumstances, schedule a consultation with one of our experienced advisors today.