Building Your Retirement Game Plan: Tax diversification (Part 5 of 5)

| August 25, 2014

The subject matter of the final installment of this 5-part series is a bit more “taxing” than the previous four parts. That’s because it addresses the importance of taking into account the potential impact of taxes on your retirement income through a process known as “tax diversification.” Just as investment diversification is a way of hedging one’s bet about which markets or individual investments will perform best – or worst – in the future, tax diversification is a way of hedging one’s bet on possible changes in tax rates and laws. Investment diversification is accomplished by spreading your assets across several different types of investments. Tax diversification is accomplished by investing strategically in accounts with different tax treatments.

Think of it like this: when it comes to how and when we pay taxes on our investments, there are essentially three types of accounts to choose from:

Taxable accounts are single-registered or joint accounts which are held outside of a designated retirement or college savings plan. You invest in them with after-tax money and you pay capital gains taxes on any earnings.

Tax-deferred accounts include investments like the traditional Thrift Savings Plan (TSP), Traditional IRAs and 401(k)s. You get to invest in these accounts with pre-tax dollars, but have to pay ordinary income taxes on any deductible contributions you made and all of the earnings when you begin withdrawing the money in retirement.

Tax-free accounts include the Roth TSP, Roth IRAs, Roth 401(k)s, and municipal bonds and bond funds. You don’t get to deduct the money you invest in these accounts, but neither earnings nor eligible withdrawals are taxed.

In all likelihood, none of these three account types is a perfect best fit for all of your investing goals. But some combination of the three probably offers you the best opportunity to accomplish your investing objectives with maximum tax efficiency.

Unfortunately, there’s no quick and easy formula for determining what that optimal combination is, because people’s financial situations and goals vary so widely, there is no one-size-fits-all solution. The only way to ensure that you have the right mix of taxable, tax-deferred and tax-free investments in your portfolio is to review and prioritize your goals, determine which tax treatment makes the most sense for each goal and then take steps to position your assets accordingly. One more thing: this isn’t necessarily a one-time process. Future changes in tax laws – or your own situation – will almost certainly require revisiting your strategy.

This article was previously printed in a First Command publication.

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