Ask the Adviser: How can I build tax diversity into my portfolio? - Rodgers & Associates

Ask the Adviser: How can I build tax diversity into my portfolio?

Taxes are on the mind of almost every American these days. Whether you’re starting your first job or retiring from a long career, taxes are a part of your life. Regardless of life stage, “tax diversity” is a great way to enhance the longevity of your portfolio. This term refers to the tax-efficient use of a variety of investment accounts, each with a different tax treatment—pre-tax, taxable, or tax-free. Balancing these types of accounts can help lower your current and future taxes.

Here, we’ll look at each type of account and outline its parameters and purpose.

Pre-tax Investment Accounts

Retirement accounts such as 401(k)s, 403(b)s and tradi­tional IRAs are considered pre-tax (also called tax-deferred). Here’s what that means:

  • These accounts are funded with money before it’s been taxed (called pre-tax or tax-deductible contributions).
  • The earnings are tax deferred, so you won’t pay taxes until you withdraw funds.
  • You’re required to take withdrawals called Required Minimum Distri­b­u­tions (RMDs) beginning in the year you reach age 73 (if that occurs between the years 2023–2032) or age 75 (if that occurs in the year 2033 or later).
  • Withdrawals and RMDs are taxed as ordinary income, and the rate depends on your tax bracket.
  • Withdrawals made before age 59½ may face an additional 10% penalty tax.

Main idea: These types of retirement accounts can help reduce your taxable income today, but due to RMDs they can also move you into a higher tax bracket in retirement.

Tax-free Investment Accounts

This category includes Roth IRAs and Roth 401(k)s, as well as Health Savings Accounts (HSAs). These accounts operate as follows:

  • Most tax-free investment accounts are funded with money that’s already been taxed (called after-tax contributions).
  • An HSA can be funded with tax-deductible contri­bu­tions or pre-tax income if you have a high-deductible health plan through your employer.
  • The earnings are generally tax deferred.
  • Roth IRA or Roth 401(k) distri­b­u­tions are usually tax free, if distri­b­u­tions are taken after age 59½ and the Roth account is at least five years old. You’ll be taxed on earnings if the withdrawals are made before age 59½ (and a 10% penalty tax may also apply).
  • HSA withdrawals are only tax free if the money is used on qualified medical expenses.
  • These accounts are not subject to RMDs.

Main idea: The benefits of Roth accounts generally arrive as you’re nearing or in retirement, because you can withdraw money tax-free.

Taxable Investment Accounts

Standard brokerage accounts, which are generally comprised of stocks and bonds, are fully taxable. Here’s what to keep in mind:

  • These accounts are funded with after-tax money.
  • You pay taxes on yearly dividends, interest earnings, and capital gains (when you sell stocks).
  • The tax amount depends on your tax bracket, how long you held an investment before it sold, and whether dividends are considered qualified or non-qualified.
  • You may be able to deduct investment losses, subject to certain tax rules.

Main idea: A standard brokerage account provides the most flexi­bility in terms of uses and withdrawals. It’s a good addition if you’ve maxed out contri­bu­tions to your retirement accounts and want to continue investing for retirement.

In a perfect world, your funds would be equally distributed across these types of accounts, but of course most situa­tions don’t allow for that. For example, higher income earners are generally more incen­tivized to max out their pre-tax accounts, after which they would add to tax-free and taxable accounts (creating an uneven distri­b­ution). The best approach is to consult your adviser and work together to determine the right allocation for your situation.