BIT (Blog in Tweet): Utilize different tax vehicles to plan for tax variability in future years.

“Diversification is the only free lunch in finance,” said Harry Markowitz, a Nobel Prize winner for his work in modern portfolio theory, but readers may be more familiar with the phrase “in this world nothing can be said to be certain except death and taxes.” With these two famous quotes in mind, we remind readers that tax diversification is an area that requires as much attention and focus as asset diversification.  As investors accumulate wealth it is important to consider how these assets will be taxed now and in the future.

The use of different account types contributes to the end returns for investors. Any account can be classified as tax deferred (e.g. 401(k) or IRA), tax-free (e.g. Roth IRA) or taxable (after-tax account where all gains and income are taxed each year).

Many investors look at the decision to invest in either pre-tax or post-tax accounts. This binary decision can leave someone with significantly more pre-tax or post-tax money. Whether this is the right decision depends on more than whether someone’s current tax rate is higher or lower than their expected income tax rate in retirement. Investors must also be correct about rates of inflation, alternative income sources in retirement and potential uses for today’s savings from reduced taxes.

This decision can be tricky. Making the correct decision requires an accurate projection of returns, subsequent withdrawal rate and even predisposition to risk in retirement (we’ll be writing plenty on this later).

Instead, we favor a blend of pre- and post-tax investing. This allows someone to hedge their projections and build tax flexibility in retirement. For example, the typical retiree looks to maximize their income without undue risk or unnecessarily jumping into a higher tax bracket.

For a client only with tax-deferred and taxable accounts, making significant purchases, such as a rental house, memorable trip or home renovation, would carry a tax liability from the distribution. Alternatively, for clients that also have tax-free accounts, they can access these funds for special situations and not have resulting tax liabilities.

This does not mean that tax-free accounts are always the correct decision. IRA and 401(k) contributions benefit the client not only in deferring taxes until retirement, but they also provide tax relief during the accumulation phase of life. An entrepreneurially minded individual tags this tax savings and attributes those funds for additional wealth accumulation activities.

Attempting to forecast prevailing tax rates, retirement income, inflation and tax regimes is a “guesstimate” at best. Knowing this, we favor clients mitigating the tax risk by having both tax-deferred and tax-free sources of income in retirement. More often than not, our wealth building clients have a SIMPLE IRA, SEP IRA or even 401(k) from a prior employer. Filling out the income sources with tax-free silos creates a tax alpha (aka generating value of base case scenario) opportunity in retirement. By engaging in proactive tax planning during wealth accumulation phase of life, you have the opportunity to yield future tax savings in retirement.


Disclaimer: Delta Wealth Advisors is a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. For more information please visit: and search for our firm name. This is for informational purposes only and is not to be construed as tax advice. This is for informational purposes only and is not to be construed as an offer or a recommendation to buy or sell a security.