The Importance of Tax Diversification

Most investors are familiar with diversification, or spreading your eggs among a variety of stock, bond and cash baskets to reduce risk. But there’s another kind: “tax diversification.”

That refers to keeping assets in a variety of accounts that are treated differently at tax time. It’s especially valuable to retirees, who are more likely to take money out of their accounts than to put it in.

Tax diversification allows you to keep tax bills to a minimum by switching your withdrawals from one account to another as your situation changes from year to year. In years when you are in a high tax bracket, you can withdraw from accounts with the smallest tax consequences, for instance.

There are three basic types of accounts.

Taxable. These are especially useful for investments such as stocks or stock funds that provide most of their returns through capital gains, or profits when a holding is sold for more than was paid. Investments owned for longer than a year are taxed at the long-term capital gains rate no higher than 15%, while those owned for a shorter period are taxed as short-term capital gains rates as high as 35%, the same as income-tax rates.

Tax-deferred. This includes traditional IRAs, 401(k)s and similar plans. No income or capital gains tax is paid until money is withdrawn, even if you sell one holding to buy another. But withdrawals are taxed at rates as high as 35%.

Tax-exempt. There is no tax of any kind on withdrawals from Roth IRAs, or from Section 529 plans used for college savings.

Retirees are often told to tap taxable accounts first, then tax-deferred and finally tax-exempt, allowing holdings with the best tax advantages to grow as long as possible. But the rule is not ironclad.

For one thing, the investor may need to withdraw more than usual in some years — for a new roof, medical expenses, travel, a down payment on a winter home or to help with a grandchild’s college expenses.

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