If you’ve even dipped your toes into the water of “financial advice” you’ve heard this one before: don’t put all your eggs in one basket. It’s solid advice that can be applied and applicable across many aspects of our lives. Personally, I’ve uttered that phrase hundreds of times when speaking about building investment portfolios. But while this advice has stood the test of time, here I’m focused on a different set of eggs… eggs that can’t be scrambled and can be tough to stomach: income taxes.
You could be confused at this point, wondering how you can put your “tax eggs” in different baskets when Uncle Sam is the recipient of all of our federal income tax payments. While it’s true we send taxes resulting from our investments to Washington--when, how and how much we send is largely impacted by the type of investment accounts we use. That’s where the concept of tax diversification comes into play.
In practice what it means is building a portfolio that includes taxable, pre-tax and potentially tax-free investment accounts. We’ll look at three options you can choose from as you build your own investment portfolio:
Pre-tax AccountsThis is where you’ll find some of your classic retirement savings vehicles; Traditional Individual Retirement Accounts, the Thrift Savings Plan (TSP), and other employer offerings like 401(k) and 403(b) plans. Other than the Traditional IRA (which may or may not be tax-deductible depending on several criteria), these plans reduce the taxes you pay today. That’s because contributions you make to these plans reduce your income for tax purposes. Your investment income in this type of plan is also tax-deferred. In other words, you pay no taxes on investment gains or income each year. Upon withdrawal, your contributions and potential earnings are generally subject to ordinary income tax. Although there are some exceptions, normally you are required to leave this type of account alone until age 59 ½, otherwise any withdrawals may be subject to taxes and penalties. All-in-all pre-tax vehicles can be a great way to save on taxes today and build for retirement tomorrow.
Taxable AccountsHere I’m talking about investments and savings that are held outside any sort of IRA or retirement account. For example a bank account (CD or savings), mutual fund or brokerage account you own individually or jointly with your spouse. You get no big tax breaks with this type of account and pay tax on taxable investment income and gains as they are realized each year. However, you do get an investment vehicle you can typically access without the restrictions associated with retirement accounts. In other words, you can normally use the money when you want without fear of penalties…although capital gains could be considered a penalty of sorts. What I like about this type of account is that you can use it for any goal you’ve got. It could be a down payment on a house next year or some “just in case” money for the kids college. Also, in retirement it gives you a source of income that you can tap into with typically much tamer tax consequences – potential capital gains as opposed to taxable income -- than pre-tax type vehicles create.
Tax-free AccountsNeed I say more? Now we’re talking Roth. Roth TSP, Roth IRAs, Roth 403(b) and the like. While contributions to any of the various Roth vehicles do not reduce your taxes today, they too accumulate over the years without taxes like the aforementioned pre-tax plans. The big benefit comes at retirement, when both your contributions and all the earnings can potentially be tapped without income tax. This could be especially beneficial if you end up in a higher tax bracket in the future. Also, with the Roth IRA (not the other Roth employer plans), you can access your contributions at anytime without taxes or penalties, so that provides flexibility. Obviously, in retirement being able to tap a pool of money without tipping the tax scales even a tiny bit is an exciting option to think about building into your plan.
In the end, consider whether building a portfolio that includes all three of these types of accounts could provide you with flexibility, control and options when it comes to how and when you access your money and pay your income taxes … now and in retirement.
Too often I’ve worked with folks who have done a great job of saving for retirement, but have done it all inside pre-tax accounts. For them, withdrawing funds becomes an antacid-inducing moment since every dollar they use represents a dollar of taxable income. So, a $5,000 vacation can require a $7,000 withdrawal to cover the taxes. That in-of-itself can be taxing…emotionally and financially.
So, the next time you hear someone caution against having all of your eggs in one basket, consider taxes as you assess where you stand.