Tax Diversification:  Strategy to Lower Lifetime Taxes and Help Assets Last

As many employers have canceled pension programs over the past several decades, retirees increasingly must rely on their assets, not pension income, to supplement Social Security benefits and cover their expenses in retirement.  While this change has significant upside potential, it also shifts enormous responsibility onto retirees to manage their savings and withdrawal strategies effectively and thereby ensure that their assets last throughout retirement.  One key element of an effective withdrawal strategy is managing the bite that taxes take from your assets.  By pursuing tax diversification while you are working and in retirement, you can reduce lifetime taxes on your investment assets and preserve greater value for your retirement nest egg.

What is tax diversification?  There are two main components of tax diversification.  The primary one involves strategically saving to (or withdrawing from) different accounts based on their tax treatment.  The second involves strategically allocating your investment assets to those different accounts in light of their expected return and taxable distributions. 

What type of account should I save to (or withdraw from) and when?  From a tax perspective, the three types of savings or investment accounts are:  taxable accounts, tax-deferred accounts, and tax-free accounts. 

• Taxable accounts.  Taxable accounts are traditional savings or investment accounts.  Investors contribute after-tax dollars to these accounts (i.e. they pay income tax on their earnings and then transfer a portion of the net earnings to their savings or investment account thereafter).  For assets in these accounts, investors pay taxes on any interest or dividends earned annually, and they pay capital gains tax on any growth in the investments when they sell the asset.  Note, however, that capital gains tax rates are lower than ordinary income tax rates—and could even be zero in certain years if/when your income is low.
• Tax-deferred accounts.  Tax-deferred accounts include traditional IRA, 401(k), 403(b), TSP, SEP IRA and SIMPLE IRA accounts.  Investors contribute pre-tax dollars to these accounts (i.e. they receive a tax deduction on contributions to these accounts in the current year), and then they pay ordinary income tax on withdrawals from these accounts in retirement.  This type of account is also subject to required minimum distributions in retirement.  As compared to taxable accounts, the assets in a tax-deferred account are worth less on an after-tax basis.  While you only pay tax on the growth in taxable accounts—and that growth is taxed at capital gains rates—you pay tax on the full amount of any withdrawals from tax-deferred accounts, and the withdrawals are taxed at the higher ordinary income rates.
• Tax-free accounts.  Tax free accounts are technically not tax free.  Similar to taxable accounts, investors must contribute after-tax dollars to these accounts, so they pay income tax on money earned and then transfer it to a tax-free account, such as a Roth IRA or Roth 401(k).  However, once the money is in the tax-free account, it can grow and be withdrawn completely tax free.  There is no tax on annual interest, dividends, capital gains, or withdrawals from these accounts.  (Note these types of accounts also include Health Savings Accounts (HSA) when withdrawals are used for qualified healthcare expenses as well as 529 accounts when withdrawals are used for qualified education expenses.)  Since investors face no tax on any portion of the withdrawals from tax-free accounts, assets in these accounts are most valuable on an after-tax basis. 

Having money in each of these three “pots” allows you to control when taxes are paid by varying the pot from which a distribution is made.  If you are in a relatively low tax bracket during a portion of your retirement (e.g. before starting to claim Social Security or take required minimum distributions from your retirement accounts), you can choose to draw some assets from a tax-deferred account or realize some capital gains in a taxable account.  These moves would generate taxable income, but you would not face a heavy tax bill because you are in a low marginal tax bracket.  Conversely, at other points in retirement (e.g. you and a spouse are both taking Social Security and your retirement account distributions are particularly high this year because you had to buy a new car and put on a new roof), you may choose to draw some assets from a tax-free account because you are in a high marginal tax bracket relative to other years in your retirement.

In addition, having assets in each of the three tax buckets can create a hedge against potentially higher tax rates in the future.  If ordinary income tax rates creep up, but capital gains rates and the treatment of Roth assets remains the same, those with assets in taxable or tax-free accounts will be better positioned to weather the storm.

What is the best investment strategy to maximize tax diversification?  As mentioned above, when you have assets in each of these three types of accounts, you can strategically place investments to try to optimize returns and minimize taxes across your portfolio as a whole.  For example:

• Since bonds and real estate investments typically generate a high level of taxable distributions on an annual basis, it makes sense to hold most of these investments in a tax-deferred account, rather than a taxable account. 
• Volatile asset classes, such as emerging market stocks, are well-situated in a taxable account since any large gains are taxed at the more favorable capital gain rate while any losses might present opportunities for realizing capital losses in a down market. 
• Since investment growth is not taxed in tax-free accounts like Roth IRAs, investors should typically keep assets with a high expected return in those accounts and minimize (or eliminate altogether) any holdings with a low expected return (i.e. keep stocks, not bonds in a Roth).

Tax policies will likely change numerous times over the course of your retirement, and your specific financial needs will change year-to-year.  Tax diversification allows the flexibility to withdraw assets from optimal sources at different times to help preserve retirement assets, and by strategically emphasizing certain types of investments in each of the three types of accounts, you can stretch your retirement assets even further.