What is Tax Diversification?

What is Tax Diversification?

I've often recommended diversifying investment holdings across asset classes in order to mitigate risk. Some experts have claimed it accounts for as much as 90% of portfolio success.

Investment diversification alone is not enough to create a well-balanced portfolio. I believe investors must consider the importance of tax diversification - and that this concept will become increasingly important as taxes rise. It is one of the most underrated financial and retirement planning concepts. The key to tax bracket management is tax diversification. Tax diversification recognizes that different types of income are taxed differently.

The tax law and your situation can change, so you don’t want only one type of income or tax break. During the working years, most income tends to be ordinary income, whether it is salary or business profits. But in retirement you often can diversify income sources.

Tax diversification is achieved by having your investments in different types of accounts: Traditional IRAs and 401(k)s, Roth IRAs and 401(k)s, taxable accounts, annuities, permanent life insurance and any others available to you. You’ll also have other sources of income, such as Social Security and perhaps some form of pension. Having different income sources allows you to use all the available strategies.

Reduce or Convert Traditional IRAs

One of the greatest obstacles to tax bracket management is having too much of your nest egg in traditional IRAs or 401(k)s. Most people don’t realize this until it is too late.

Traditional IRAs (and other forms of tax deferral) are great during the accumulation years. Yet they create three problems during the distribution years...

One problem is that all distributions are taxed as ordinary income, facing your highest tax rate.

Another is that after age 72, minimum distributions are required....many will lose control of their income at this point.

Finally, and most importantly perhaps, most accounts are held in securities and are subject to market risk. A market drop +-5 years from retirement can lead to 'sequence risk', which is essentially dollar-cost averaging in reverse. This risk cannot be overstated for those nearing or just in retirement.

One strategy is to convert all or part of the traditional IRA to a Roth IRA and/or a permanent life insurance policy (a LIRP). You pay taxes on the converted amount, but the money grows tax-deferred, and future distributions to you and your heirs are tax-free (assuming the policy is properly constructed and funded). The advantage of the LIRP is the leveraged death benefit which can multiply the value to the estate.

Most people don’t want to prepay taxes. It goes against one of the longstanding principles of tax planning. But when taxes will be higher in the future, especially when you’ll be faced with an array of stealth taxes, paying taxes now can make sense.

Having multiple types of investment -accounts allows you to sequence your retirement distributions. This alone can mitigate some retirement risks.

An advantage of a Roth IRA and LIRP is that distributions from it, no matter how large, aren’t included in AGI. That is a big help in avoiding the stealth taxes triggered by higher AGI.

Amy Corrales

BSN, RN, LNC, Holistic Wealth Enthusiast

2 年

Well put!

Patrick Waters

Vice President of Business Development

2 年

This is so overlooked in retirement planning

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