We talk a lot about diversification, which is generally approached in the context of the types of investments one might select for their portfolio. Many of us may have even been taught a common lesson from Great Depression era investors – don’t put “all of your eggs in one basket,” be it one investment or even one financial institution.
Through a more modern lens, one might think broadly in terms of the percentages a portfolio holds in stocks, fixed income, alternatives, and cash. At a deeper level, one might think in terms of allocating among specific styles, such as growth and value; or domestic and international; or sectors like financials, industrials, energy, and consumer discretionary; or, even among themes like ESG or crypto.
The role of diversification is to serve as a risk manager for your investments. Yet, there’s another factor in diversification that plays a major role in sound long-term financial and retirement planning: tax diversification.
As an example, an investor who’s entire savings is held in a tax-deferred account, such as a company-sponsored 401(k) plan, while that account may hold many different types of investments, the investor may not be properly diversified from a tax planning perspective. Why?
Financial planning as a comprehensive approach looks to project future growth, spending, cash flow needs, as well as the taxable impact of each of these activities. While the risk of tax law changes to the financial plan can be significant, we can take steps to manage tax risk by diversifying the types of accounts used for long-term savings, as well as the order of distribution from these accounts.
In a real-world scenario, suppose an investor has a large 401(k) plan representing 40% of total net worth, a Roth IRA at 15%, and a taxable investment account at 10%. The remaining net worth would be represented by other assets, such as a primary residence.
At a high level, this could be a good example of a tax diversified investor. But, what happens when retirement arrives and there’s a need to take distributions from retirement savings? In this scenario, the largest single source of assets – the 401(k) at 40% of total net worth – is likely to be subject to the highest tax rate, especially in the earliest years of retirement. This can be a costly oversight.
For many investors, and their advisors, a primary concern is saving as much as possible and investing efficiently to reach a projected retirement success rate. A more thoughtful approach to how this is implemented during the accumulation years can add the benefits of tax efficiency when it’s finally time to use the money you’ve worked for many years to save.
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