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The Importance of Tax Diversification Thumbnail

The Importance of Tax Diversification

Harry Markowitz, a Nobel Prize winner for his work in modern portfolio theory, once said, “Diversification is the only free lunch in finance.” This quote is in reference to the mixture of stocks and bonds. For enterprising investors, this “free lunch” can extend into their taxes. 

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 retirement account can be classified as one of the following:

  • Tax deferred (e.g. 401(k) or IRA), 

  • Post-tax (e.g. Roth IRA) 

  • Taxable (account where all gains and income are taxed each year; no tax benefit to depositing or withdrawing). 

For many investors, they see a simple decision about investing in either pre-tax or after-tax accounts. They consider their financial standing, compare pros and cons of both accounts, and then make an educated guess. 

Unfortunately, this approach is a mistake. Thinking of tax diversity as an either/or scenario is reductive, and a black-or-white-, binary answer of pre-tax or after-tax could result in someone with significantly more money in the wrong tax structure. And for folks like small business owners, retirement strategies could wind up costing you tens of thousands in taxes.

Retirement Options for Business Owners: a Blended Approach

Making sure this is the right decision for the business owners retirement savings account 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.

Making the correct decision requires an accurate projection of returns, subsequent withdrawal rate and even predisposition to risk in retirement.

Instead, we favor a blend of pre- and post-tax investment accounts. This allows someone to hedge their projections and build tax flexibility in retirement.

The typical retiree looks to maximize their income without undue risk or unnecessarily jumping into a higher tax bracket. Having tax flexibility between IRA’s and Roth IRA’s can help in income maximization efforts.

Breaking Down the Pros and Cons of Pre-tax and After Tax Accounts

For a client only with tax-deferred and taxable accounts, making significant purchases, such as a rental house, memorable trip or home renovation, carries a tax consequence from the distribution. These significant purchases can easily lead to a higher tax bracket that affects both income taxes and Medicare premia. 

Alternatively, for clients with a Roth IRA, they can access these funds for special situations and not have resulting tax liabilities. When clients do not have an existing Roth IRA, we prefer to plan major distributions by completing Roth IRA conversions in the years before the major expense. This helps smooth the tax liabilities while still freeing up the funds for the purchase. This does not mean after-tax accounts are always the correct decision.

This does not mean that after-tax 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 such as rental homes or business investments.

We’ve also seen scenarios where clients diligently save for retirement. Towards the end of their working career, they begin to save even more in taxable accounts that are first used to fund the beginning years of retirement. 

The inadvertent result is that the client builds a sort of tax bomb detonated by required minimum distributions from IRA’s and Social Security. These two sources can easily push retirees into tax brackets higher than expected. Moreover, because both RMD’s and Social Security benefits typically increase each year, retirees can find themselves in an unnecessarily high tax bracket.

Delta Wealth Advisors: Finally an Easy Choice for Tax Diversification

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. Filling out the income sources with tax-free silos creates a tax alpha opportunity in retirement. By engaging in proactive tax planning during the wealth accumulation phase of life, you have the opportunity to yield future tax savings in retirement.

This report was prepared by Delta Wealth Advisors 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. Neither the information nor any opinion expressed it so be construed as solicitation to buy or sell a security of personalized investment, tax, or legal advice. For more information please visit: https://adviserinfo.sec.gov/ and search for our firm name. 

This is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. Information in these materials are from sources Delta Wealth Advisors deems reliable, however we do not attest to their accuracy.