When most people think about diversification, they think about diversifying investments. This would include using funds to invest in large number of business with a relatively small amount of money. Stock diversification is a common risk management technique that reduces your exposure to one company.
In this article, we’re going to talk about a form of diversification that is not mentioned enough, tax diversification. Like stock diversification, the purpose of tax diversification is to reduce your risk and improve efficiency of an investment. Here, I will detail the most common benefits of tax diversification and why it is a necessary part of any good portfolio.
This is the most important benefit of tax diversification. As you begin retirement, your withdrawal strategy will have a major impact on your income tax bracket, how much in taxes you pay, and ultimately, how much money is left in your pocket each month. This is the number one reason why tax diversification is so important. By having money in tax-deferred accounts, tax-free accounts, and taxable accounts, you’re able to create the best withdrawal strategy and minimize your overall taxes paid.
What happens if the government changes the rules with taxes and investing? This happens just about every year in one form or another. Sometimes these changes result in minimal impact and other times it’s a complete game changer. For example, in 2015, there was a proposal from the White House to enact required minimum distributions (RMD) on all retirement accounts, including Roth IRAs. While this proposal didn’t end up going through, it would have been a game changer for retirement planning as well as legacy planning. That is a great example of legislative risk, the risk of the government changing the rules.
It is important to keep in mind that trying to predict what tax laws will be in the future is an impossible task. The best way to handle this legislative risk is through proper tax diversification.
Whether you’re talking the next few years or during your retirement, it is very likely that you’ll have some unexpected expenses along the way. Sometimes, these expenses are large enough that you need to tap into your investments to pay for them. However, this will almost always create tax consequences for you. By having tax diversified accounts, you’re able to minimize the tax impact of these withdrawals.
To sum everything up, when you have multiple types of accounts with various tax attributes (tax diversification), you can increase your flexibility and reduce your risk. More flexibility and less risk is always a key component of financial success over time.
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