Even if you’re only in your 20s or early 30s, it’s never too early to begin retirement planning. A good enough reason is that the sooner you start saving, the more your money can grow.
You can think of your savings now as eggs. By the time you hit retirement, they would’ve turned into a full-blown brood. “They” could be a lifesaver, especially considering you may need an average of $1.8 million to retire.
However, there’s one more trick you can use to maximize your retirement savings: tax diversification. It’s among the most commonly used tax strategies that can result in lower taxes over one’s lifetime.
We’ll discuss the fundamentals of tax diversification to help you get started, so read on.
What Is Tax Diversification?
Tax diversification is a practice wherein you spread your savings over different investment accounts with various tax treatments. These include tax-advantaged, tax-free, and fully taxable accounts. The strategic use of these accounts can help reduce your taxes now and while you’re in retirement.
Tax-Advantaged Investment Accounts
When you invest in a tax-advantaged account (tax-deferred), you fund it with pre-tax contributions. This means your investment dollars go straight into your accounts without getting diminished by taxes.
Since you don’t have to pay taxes on them yet, you’re putting higher amounts into your savings accounts. This gives you the advantage of earning more with compound interest.
These accounts also let you subtract the amount of your contributions from your taxable gross income for the year. As a result, you’ll owe the federal government fewer taxes.
Some of the most common tax-advantaged investment accounts are the following:
- Traditional individual retirement accounts (IRAs)
- Traditional 401(k) plans
- Traditional 403(b) plans
Your employer may also match your contributions, further accelerating your savings.
You can withdraw from your tax-advantaged accounts in retirement or when you turn 59 ½. When you do, you’ll have to pay taxes on the withdrawals, also called distributions.
Tax-Free Investment Accounts
These investment accounts aren’t “tax-free” per se, as you’ve already paid taxes on the money you’ve contributed to them. In short, you fund these accounts with post- or after-tax money. The advantage is that once you’re in retirement and withdraw from them, you can do so completely tax-free.
Some examples of tax-free investment accounts include the following:
- Roth IRAs
- Roth 401(k) plans
- Roth 403(b) plans
Roth 401(k) plans are among the most popular, as more employers now offer them: 89.1% in 2022, compared to 58.2% that did in 2013. So, with nearly nine in 10 employers sponsoring such plans, yours likely do, too. You can ask the human resource department if your company offers such plans.
Like tax-advantaged accounts, you can withdraw from tax-free accounts when you turn 59 ½.
Fully Taxable Investment Accounts
A fully taxable account is an investment account with tax deductions. You fund it using post-tax money (money you’ve already paid taxes on). You’ll also pay taxes on whatever you earn from it.
Such accounts let you buy and sell various investment media that can help diversify your portfolio. These include stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
How Tax Diversification Can Boost Your Financial Portfolio
One of the primary benefits of tax diversification is that it can help you decrease your tax bill.
For example, suppose you withdraw from your tax-advantaged accounts when you retire. This can lower your tax bracket, reducing the taxes you pay as you maintain your accounts.
Another benefit is strategically saving and withdrawing money without a significant tax burden.
For instance, investing in a traditional 401(k) plan can reduce your taxable income, and you earn more in interest with your pre-tax money. If you also invest in a Roth IRA, you can withdraw from this first during retirement, as your withdrawals will be tax-free. You can then turn to your traditional 401(k) plan if you’ve maxed out your Roth IRA.
If you’re unsure which tax-advantaged accounts best suit you, you may want to consult with tax reduction services. They can help you make investment decisions that can minimize your tax liability.
What About Fully Taxable Accounts?
With all those benefits of tax-efficient accounts, you may wonder if investing in fully taxable accounts is even worth it.
Yes. You should still consider investing in these accounts because they’re more accessible and flexible when you need to cash in on them. They also help you diversify your overall investment portfolio.
Accessibility and Flexibility
If you need money for an emergency, you can sell some of your stocks (if their price is high). Bonds also typically pay interest every six months and mature in a few years (e.g., 2, 3, 5, and 10 years).
By contrast, you can’t just take money from tax-advantaged and tax-free accounts whenever you want. If you withdraw from them before you turn 59 ½ years old, you may have to pay an extra 10% penalty tax.
Portfolio Diversification
By investing in taxable accounts, you can create a more diversified portfolio.
Portfolio diversification means to divide your assets over different investments. In doing so, you also spread your risk and rewards.
For example, if you were to invest in traditional and Roth IRAs alone, you risk missing out on profiting from stocks and bonds. And if you were to need money before retirement, you may have to tap your tax-advantaged accounts. This can compromise your savings, and you’d also face penalties for early withdrawals.
But if you invest in stocks, bonds, mutual funds, and ETFs, you’d have more income sources, even before retirement. As a result, you’ll be less likely to touch your IRAs, so they’ll just keep growing until you need them.
Maximize Your Investments With Tax Diversification
Tax diversification is a smart financial move that helps you save for retirement and enjoy tax benefits. It lets you maximize your investment dollars now and help you prepare for your later years.
However, remember that the sooner you start saving, the more time your money can grow into your retirement. That’s why, as early as now, consider opening and contributing to IRAs. Lastly, don’t forget to diversify with taxable accounts.
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