While watching the presidential debate the other night, I saw a small poll pop-up on the screen that indicated the topics most pressing for people. Not surprisingly, taxes were near the top.
It's hard to know what, if any, changes are going to be in place in the next few years, let alone when you are in retirement. So just like it makes sense to diversify your investments in different asset classes, it also makes sense to invest in a way that provides you tax diversification.
Tax Diversification is the strategy of spreading your assets across different types of accounts with the goal of paying the least amount of money to Uncle Sam.
We don't know how capital gains will be taxed in the future, or what ordinary income tax rates will be, so it makes sense to have investments in many different tax environments.
For example - Your 401k plan
This is a form of a Tax-Deferred Account. Your money is contributed into your 401k account on a pre-tax basis and the taxes on your money are deferred until you start withdrawing them in retirement. At that time, withdrawals from your Traditional IRA/401k are taxed as ordinary income, which means that money is taxed like a paycheck. In retirement, you may already have other income sources that are going to be taxed in this fashion such as a pension or your Social Security payments.
What if all of your savings are in a retirement account like a 401k, and taxes increase greatly in the future? You may not be in a very good position to control how much you are going to pay in income taxes. A way to implement a Tax Diversification Strategy would be to invest money in additional accounts like a Roth IRA which is a Tax-Free Account.
Also, you can invest in a brokerage account which is considered a taxable account. Gains on your investments in a taxable account are taxed at Capital Gains Rate. Long Term Capital Gains are taxed at a much lower rate today than money withdrawn from a retirement account like a 401k.
The Long Term Benefit of Tax Diversification
No one knows how taxes will change over time and they will change. Investing in different tax environments puts you in a good position to get the cash flow you need from your investments in retirement, while being in more control of how much you pay to Uncle Sam. Pay him the least amount possible.This can definitely help your nest egg last longer.
Listen to my full podcast below:
If you’d like help reviewing your investment strategies and saving for retirement, please contact Casey Boland via email [email protected] or 513-598-5120.
Date Posted: 10/06/2016 Advice provided in this article is meant for educational purposes only and financial education is important to us. Before making decisions regarding your personal financial situation, please consult an advisor or conduct your own due diligence. If you would like to discuss your Retirement Income Plan with an HCM Wealth Advisor, please give us a call – 513-598-5120. Located in Cincinnati, Ohio, we serve clients in 28 states, and we’d love to help.