We hear a lot about diversifying across asset classes — owning stocks, bonds, real estate, etc. We also hear a lot about diversifying within asset classes — owning mutual funds of hundreds of stocks rather than owning a few individual stocks. But there’s another, lesser-known form of diversification from which you could benefit: Tax diversification.
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What is Tax Diversification?
Tax diversification is the strategy of spreading your investments out across each of the different types of accounts:
- Taxable accounts
- Tax-deferred accounts (i.e., traditional IRAs, 401(k) accounts, or 403(b) accounts)
- Tax-free accounts (i.e., Roth IRAs or Roth options within a 401(k) account)
When deciding between tax-deferred accounts or tax-free accounts, you’re answering the question “Do I want to be taxed on this now, or would I rather be taxed on this later?” In its simplest form, the decision comes down to how your current tax bracket compares to the tax bracket you expect to be in when you withdraw the money.
- If you expect to be in a higher tax bracket in retirement, it makes sense to put the money in a tax-free account (like a Roth IRA).
- If you expect to be in a lower tax bracket in retirement, it makes sense to put the money in a tax-deferred account (like a traditional IRA).
Two Reasons It Pays to Tax Diversify
The first and most obvious reason for tax diversifying is that it’s impossible to know precisely what your tax rate will be in retirement, especially if retirement is still many years away. Based on current tax rates you may be able to say that your retirement tax bracket will be lower than your current one. But who’s to say that tax rates won’t change?
By spreading your investments across both tax-deferred and tax-free accounts, you can minimize the risk that you’ll be caught off guard by a significant change in tax rates. The second reason it pays to tax diversify is simple math: Putting all of your investments in either tax-free accounts or tax-deferred accounts is unlikely to be the most tax-efficient strategy.
For example, imagine an extreme scenario in which an investor has all of his retirement savings in a Roth IRA. Once he retires, none of his withdrawals would be taxable. At first glance, this may sound wonderful, but it’s really a huge waste.
If the investor had forgone some of his Roth contributions in order to contribute to a 401(k) or traditional IRA, he would have increased his taxable income in his low tax bracket years in exchange for reducing his taxable income during his high tax bracket years. That sounds like a good trade-off to me.
How to Tax Diversify
Because of all the variables involved, there’s no way to know precisely which breakdown of tax-deferred, tax-free, and taxable accounts is best. The strategy I suggest for most investors is to allocate their investment dollars in the following order:
- Take full advantage of your employer’s 401(k) match,
- Max out your Roth IRA,
- Go back to your 401(k) and max it out,
- Invest in taxable accounts.
This way you’ll be taking advantage of your employer-provided match, taking advantage of the low-cost investment options in an IRA (as compared to the high-cost funds frequently offered in a 401k), and achieving tax diversification all at once.
About Investing Made Simple
Mike Piper is the author of Investing Made Simple: Index Fund Investing and ETF Investing Explained in 100 Pages or Less. The book explained the following in plain-English with no technical jargon:
- Asset Allocation: What does it mean, why is it so important, and how should you determine your own?
- How to Pick Mutual Funds: Learn how to choose funds that are mathematically certain to outperform the majority of other mutual funds.
- Roth IRA vs. Traditional IRA vs. 401(k): What’s the difference, and how should you choose between them?
- Financial Advisors: Learn what to look for as well as pitfalls to avoid.
- Frequent Investor Mistakes: Learn the most common mistakes and what you can do to avoid them.
- Calculate Your Retirement Needs: Learn how to calculate how much you’ll need saved in order to retire.