What Is Tax Diversification?

Diversification is an important strategy that financial advisors and industry experts often recommend. While most often discussed as a technique to reduce risk exposure and spread it across various investments, the concept can also apply to taxes on different types of accounts and securities.

Specifically, this is a strategy known as tax diversification, which involves utilizing differently taxed accounts and investments in your portfolio. In this article, we’ll detail how the concept works and highlight its benefits. We’ll also discuss how a financial advisor can work closely with you to implement the strategy effectively.

Tax Diversification Basics

Tax diversification is a strategy that comprises using investment accounts with different tax classifications to save money and smartly minimize the amount you pay on taxes. In doing so, this allows you to take advantage of the benefits of various accounts, some without tax advantages, like brokerage accounts, and others with defined benefits, like 401(k)s or Roth-designated vehicles.

“As you accumulate wealth, ideally you want to save and invest in accounts with different tax treatment,” explains Chris Urban, CFP, RICP, founder of Discovery Wealth Planning in McLean, Virginia. “For example, good tax diversification might mean you have a pre-tax account (i.e. Traditional 401k and/or IRA), an after-tax account (i.e. Roth 401k and/or Roth IRA) and a taxable brokerage account,” he adds.

Employing the strategy is especially useful as your portfolio grows and you need to consider wise places to allocate your money for retirement. This is because it involves utilizing the benefits of varying tax-advantaged accounts (i.e., either tax-free or -deferred), thus reducing your tax liability on withdrawals and granting you flexibility on how you want to access your savings.

“Having a good pot of each type of money gives you flexibility in retirement to pull funds from the most advantageous source, given your circumstances at the time in each particular year,” says Keith Spencer, CFP, founder and financial planner at Spencer Financial Planning, and Certified Member of the Alliance of Comprehensive Planners (ACP).

How It Works: Different Account Types

Diversifying taxes, as mentioned, involves taking advantage of the benefits and flexibility of various accounts with different tax classifications. To minimize risk and reduce tax liability, this can involve accounts where you save and invest for retirement or others where you invest for more short-term returns, such as a brokerage account.

“The idea is that it is useful to have a healthy mix of pre-tax money (such as Traditional accounts), tax-free money (such as Roth and HSA accounts), and taxable money, especially if you’re headed into retirement,” Spencer explains. By implementing this idea into your saving and investing strategy, he adds, you’re “less beholden to whether future tax rates are higher or lower than current tax rates, as you have money in each type of account.”

As Spencer points out, there are three primary types of accounts to keep in mind:

Taxable

A taxable account is any where you must pay income taxes on your earnings within it. Most often, this refers to brokerage accounts, but it can also include high-yield savings accounts where you earn interest. In a taxable brokerage account, you’ll often invest your after-tax earnings in equity investments such as individual stocks, mutual funds, and exchange-traded funds (ETFs) and fixed-income securities such as bonds and certificates of deposit (CDs).

In a taxable account, you must pay taxes on any returns, including interest and dividends, generated from your investments. You must also pay capital gains tax on any profit you earn from selling investments in the account.

Tax-Deferred

Another common subset are tax-deferred accounts, which usually take the form of retirement investment vehicles. Common examples include:

• Traditional 401(k)s
• 403(b)s
• 457(b)s
• Pension plans
• Individual Retirement Accounts (IRAs)

In these accounts, you contribute pre-tax money — often directly from your salary or paycheck — and then can invest and grow the funds with compound interest. The idea behind allocating money to these accounts is that once you reach retirement age, you’ll hopefully be in a lower income tax bracket than when you were working. Therefore, this allows you to withdraw the funds with less tax liability.

Tax-Free

The third type of account you may incorporate in your tax diversification strategy are those with tax-free benefits. Like tax-deferred accounts, these are often accounts that allow you to stow away money for a specific goal, such as retirement or saving for a child’s college education. Below are typical examples of tax-free accounts:

• Roth IRAs
• Roth 401(k)s
• 529 college saving plans
• Health Savings Accounts (HSAs)

In these accounts, you contribute after-tax dollars and can invest and enjoy compound growth. Unlike taxable brokerage accounts, you won’t need to pay taxes on income from dividends, interest, or capital gains. When you’re eligible to withdraw (rules vary by account), you can take tax-free distributions.

Benefits of Tax Diversification

Implementing tax diversification into your existing financial plan comes with a range of benefits. For instance, it lets you maximize contributions in retirement accounts and vehicles and allows you to collect the benefits that multiple types of accounts yield.

Below is a more specific breakdown of the strategy’s pros:

Maximize Contributions

One of the most prominent advantages of diversifying tax treatments is that, as you do so, you’ll be able to maximize contributions in various tax-advantaged accounts. For instance, if your objective is to build substantial savings for retirement, then by putting money into different retirement vehicles (e.g., a 401(k) and Roth IRA), you’ll have the capability to max out annual contributions for each account, thus growing your savings faster.

Chance to Diversify Investments

An ancillary benefit of considering spreading your funds across accounts with different tax attributes is that it gives you the chance to also diversify your investments. By having different types of accounts in your portfolio, you can select unique goals and time horizons for each one.

For example, you may have a different asset allocation in a taxable brokerage account than you would in a 401(k) or IRA. In the former, you might focus on more short-term earnings, whereas each of the latter accounts are more positioned for long-term savings goals.

Withdrawal Flexibility in Retirement

Diversifying taxes across accounts also affords you a heightened flexibility in withdrawing money, specifically for retirement. Tax-deferred accounts, for instance, incur taxes upon withdrawal, while tax-free accounts don’t. If you’ve allocated funds to both accounts, you have more flexibility to decide where to begin accessing savings.

“A huge benefit of tax diversification for early retirees is that they can better control their taxable income in retirement, which could help them qualify for premium tax credits, offsetting much of their healthcare expenses pre-Medicare,” observes Thomas Cook, CFP, EA, Certified Member of the Alliance of Comprehensive Planners (ACP) and founder of Retire To Tellico, a wealth management firm in Tennessee.

Prepare for Uncertain Tax Codes

Diversifying taxes also helps you prepare for the likely scenario where tax codes change, potentially affecting how you could withdraw funds in the future. “Just as markets have future uncertainty, and it’s wise to diversify, the same applies to taxes,” says Cook. “There is future uncertainty about what the tax code will look like, as at times, it feels as if written in pencil. It changes regularly with new legislation,” he adds.

If tax rates were to increase, for example, it would be beneficial to have accessible assets in a Roth-designated tax-free account to protect yourself from having to distribute funds from a tax-deferred plan.

According to Urban, “Good tax diversification will give you some flexibility and ‘room to maneuver’ regardless of what the tax legislation is at the time you are drawing down your assets.”

How a Financial Advisor Can Help

Tax diversification is a nuanced strategy that requires a strong understanding of the varying tax characteristics of various accounts and vehicles. It also necessitates a decent grasp on the changing landscape of tax codes and laws. Therefore, it’s a good idea to implement the practice with the assistance of an experienced financial advisor or tax professional.

“A financial advisor can help you plan to lower your taxes today and, in the future,” Cook says. In practice, this can take many different forms. Tax diversification will be one piece, although an important one, to the puzzle of managing your taxes in the present and future phases of your life.

“By contributing to different accounts with different tax treatment, thereby paying taxes at different times, you’re not quite as susceptible to the effects of tax rates moving materially higher or lower in the future,” says Spencer. However, he notes, “Actually implementing this is probably more art than science. You can’t know the ‘right’ thing to do, because we don’t know what the future holds.”

However, consider that an expert will often tailor a plan to fit your specific needs and goals and, ideally, will be informed on the best practices of optimizing your taxes in the bounds of the law, even as it changes.

If you would like to find a financial advisor and are unsure where to start, we recommend using this free matching tool. After answering a quick set of questions, you’ll be presented with an expert that fits your needs and goals.

Frequently Asked Questions

Why is tax diversification important?

Tax diversification is important because it enables you to maximize retirement and investment account contributions, minimize risk, and potentially reduce your tax liability. This can give you more options and help you save money during important phases and life events, such as retirement or paying for children’s education.

What benefit does diversifying tax-advantaged accounts have on retirement?

Employing tax diversification across tax advantaged accounts has many benefits if you’re nearing retirement or have already begun it. However, one of the most important is the flexibility it grants you when you need to withdraw your funds. Per Urban, “[O]nce you get to retirement, you will have much greater flexibility with drawing down your assets (aka spending your money) in a tax-efficient manner if you have assets to pull from in accounts with different tax treatment.”

What does tax diversification look like in practice?

While tax diversification can take several different shapes depending on your goals and circumstances, advisors often use it to help clients plan for their retirement. This is because it grants you more control over how you want to withdraw money.

Cook explains, using the example of retirement accounts, “A common strategy to consider is to convert money to Roth in the years of retirement before Social Security or Required Minimum Distributions.” He continues, “This is because you can potentially get money out at a lower tax rate and still have decades to reap the benefit of tax-free growth in your lifetime or maximize the after-tax spendable dollar benefit for your heirs.”