Tax Diversification

My last newsletters have covered the three categories that all investment accounts fall into.  Today, I’m going to sum it all up and give you the bottom line. 

The Three Categories are:

1.  Tax-deferred.  The main example is the Traditional IRA.  But other types include Traditional 401(k) and 403(b)s, Profit Sharing Plans, SEP and SIMPLE IRAs.
2. Taxable.  The main example is your checking account.  But this category also includes most investments in Individual or Joint ownership.
3. Tax-free.  The main example is the Roth IRA.  HSAs, Flex accounts, and municipal bonds could also fall into this category. 

So, what’s the bottom line?  Which is the best one?

There isn’t a best one.  They all have their place.  It is no secret that I believe that we should diversify our investments between the five major asset classes of cash, stocks, bonds, real estate, and commodities. 

Just as we should diversify from an investment standpoint, we should diversify from a tax perspective as well. 

Let me explain.

If you have all your assets in the tax-deferred category, you may very well pay just as much in income taxes in retirement as you did while you were working.  When it comes time to replace your vehicle or your roof, you may think twice about withdrawing the money from your IRA because of the brutal tax consequences.  Instead, you may feel the only option you have is to take out a loan.  Also, when you pass away and it’s time to pay the probate costs, IRAs (or any asset having a beneficiary designation) will be your executor’s worst nightmare.  All the money passes directly to beneficiaries, which is a generally a good thing.  But it leaves the executor with no money to pay the bills until the estate is closed.

If you have all your assets in the taxable category, you’ll always be tempted to let the tax tail wag the investment dog.  If you have an investment that has a sizable gain, you’ll be tempted to hang on to it too long in order to avoid the capital gains.  If you have an investment with a loss, you’ll be tempted to sell it to lock in the capital loss, but you may do this right before the investment starts moving up again.  Having all your money in taxable accounts can also create a massive headache each year in tax preparation.  Finally, when you pass away, it takes a lot longer for your beneficiaries to receive their inheritance.

If you must have all your money in one place, the tax-free category is definitely the place to have it.  However, even this has its pitfalls.  First, there is the chance that Congress will make Roth’s taxable some day.  Gasp!  Surely, you say, those good folks who watch out for our souls wouldn’t do such a thing.  Unfortunately, tax laws change all the time.  Generally, Congress does grandfather in the old accounts, but not always.  Even if the Roth doesn’t change, there is still the same estate liquidity issue mentioned under tax-deferred accounts above.

BUT, if you have some money in each of the three buckets, life (and death) is so much easier.  Proper planning allows you to minimize your taxes over time.  And if Washington gets greedy, and rewrites the playbook halfway through the game, you have options.      

For all these reasons and many more, tax diversification is the name of the game.