The Verus Team

Tax Diversification

By: George Shirley. Opinions are those of George Shirley and not necessarily those of RJFS or Raymond James.

In the context of investing, diversification usually refers to owning different assets in an attempt to reduce the exposure to any one particular risk.  This can be accomplished by owning a number of companies in different sectors, with different sizes; owning funds with different objectives (growth/value) owning different asset classes (fixed income, equities, real estate)  all following the guidance of “don’t put all your eggs in one basket.”

One area of diversification that does not get enough attention however, is tax diversification; owning assets in taxable (standard brokerage account, bank account), tax-deferred (Traditional IRA, 401k 403b, fixed and variable annuity), and tax-free accounts (Roth IRA, certain cash value life insurance).   While this may not seem to be a significant concern--especially during the accumulation phase of your life-- we find we spend a lot of time considering strategies to maximize the after-tax income in the distribution phase, and the tax efficiency of assets that are passed on in the legacy phase.  Having different “buckets” to draw from provides the opportunity to earmark them for different purposes.   And when there is an abundance of funds in tax-deferred investments, this can reduce the after-tax income received, especially when the distributions of the assets are forced with required minimum distribution after age 70 ½.  

Knowing what types of investment to own in which type of account is another consideration as well.  Higher yielding taxable investments may make more sense in tax-deferred or even tax-free accounts, while low dividend paying equities and municipal bonds may be more appropriate in a traditional brokerage account.  Consider the scenario of owning a stock that increases in value over time.  In the traditional IRA, the gain is fully taxable as income when it is withdrawn; in the Roth IRA, that gain is not taxed when realized, nor is it taxed when withdrawn; in the taxable brokerage account, it is taxed as capital gains when realized—3 different scenarios for the same security.   

It can be tempting to look at your entire net worth without taking into consideration the after tax values of everything, but once you look at the amount of tax deferred assets and long with the likely tax due upon distribution, that number can be a great deal lower. It’s not what you earn but rather what you keep.   When creating a retirement income strategy, the taxable nature of the actual investments that you own need to be considered.  And given the near certainty of changes to the tax code over time, diversification of the taxation of your accounts deserves your attention. It can provide needed flexibility in your distribution options.        

Diversification does not ensure of profit or guarantee against loss. This information is not intended as a solicitation or an offer to buy or sell any security or investment product referred to herein. Investments mentioned may not be suitable for all investors. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Every investor's situation is unique, you should consider your investment goals, risk tolerance and time horizon before making any investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. While I am familiar with the tax provisions of the issues presented herein, I am not qualified to render advice on tax or legal issues. These matters should be discussed with the appropriate professional.