Tax Diversification - The 3 Asset Location Buckets

You may have heard of diversification for investments, but did you know there is a such thing as diversification for different investment account types? Tax diversification is when you have diversity amongst different accounts that have different tax structures. This gives you greater flexibility in retirement by having accounts with different tax treatments: tax-deferred, tax-free and taxable.

Tax-Deferred

• Contributions to a tax-deferred may be tax-deductible in the year they are made, reducing your taxable income in that year. You also don’t pay taxes on the gains (interest, dividends, or capital gains) throughout the year. Taxes are paid when you withdraw the funds, typically in retirement, after age 59.5.

• Examples of tax-deferred accounts:

  • Traditional IRA

  • Traditional 401(k)

  • Traditional 403(b)

  • SEP IRA

  • Simple IRA

  • 457 Plan

• Pros:

  • Immediate tax savings when contributing (contributions reduce taxable income).

  • Potentially lower taxes paid if you withdraw funds in a lower tax bracket in retirement.

• Cons:

  • You’ll pay ordinary income taxes on withdrawals from both contributions and earnings.

  • Required minimum distributions (RMDs) typically start at age 73, forcing you to withdraw funds and pay taxes even if you don’t need them.

Tax-Free

• Contributions to this account type are after-tax dollars (no upfront tax deduction). You also don’t pay taxes on the gains (interest, dividends, or capital gains) throughout the year. When you withdraw the funds, you don’t pay any taxes, as long as certain conditions are met (like being at least 59.5 and having the account for 5 years or more).

• Examples:

  • Roth IRA

  • Roth 401(k)

  • Roth 403(b)

  • Roth 457

• Pros:

  • No taxes on withdrawals, including both contributions and earnings.

  • Ideal for long-term high growth, especially if you expect to be in a higher tax bracket in retirement.

• Cons:

  • Contributions are made with after-tax dollars, meaning no immediate tax deduction.

  • Income limits apply for Roth IRAs, so high earners may not be eligible.

    • However, you can do the “Back Door” Roth

Taxable

• This account type is unique because there are no tax benefits. Contributions are after-tax and money is taxed as it is gained. However, depending on how that money is gained, it can be taxed at more favorable rates.

  • Interest earned is taxed as ordinary income.

  • Dividends may be taxed as qualified dividends (lower tax rate) or ordinary income.

  • Capital gains are taxed when you sell an investment, with long-term capital gains being taxed at a lower rate than short-term gains.

• Examples:

  • Brokerage Accounts

  • Savings Accounts

• Pros:

  • No contribution limits or restrictions on withdrawals. You can deposit as much as you want each year and can take the money out at any age.

  • You can take advantage of tax-loss harvesting to offset gains with losses.

• Cons:

  • You pay taxes on your earnings each year + realized gains.

  • Higher taxes on short-term capital gains (taxed as ordinary income). However if you held the shares for longer than a year, they are taxed as long-term capital gains (which are either 0%, 15% or 20%).

Summary

Generally, tax-deferred accounts are great for reducing current taxes, tax-free accounts are beneficial for long-term growth with no taxes on withdrawal, and taxable accounts offer flexibility but may result in annual tax obligations. When you have good tax diversification, you can get the benefits of each account type, which become very powerful in retirement.

Not only that, understanding tax diversification means holding different types of investments in each account.

• Tax-Deferred accounts

  • Funds that tend to generate a lot of short-term capital gains

  • High income producing investments like bonds

• Tax-Free accounts

  • High growth investments (such as equities)

• Taxable Accounts

  • Tax-managed funds

  • ETFs with tax efficiency (like broad market index funds)

Thanks for reading & I hope you found value in this post.

-Kolin

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If you are looking to get organized on your finances, read this post: Getting Your Finances Organized As A Newly Married Couple

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Disclaimer: The content provided in this blog post is for educational purposes only and should not be considered as financial advice or tax advice. While every effort has been made to provide accurate and up-to-date information, the content on Money Matters For Two is based on personal research, opinions, and experiences. The financial landscape can change rapidly, and what may be applicable at the time of writing may not necessarily be applicable in the future.

Any financial decisions you make based on the information provided here are entirely at your own risk. Money Matters For Two encourages readers to do their own research and, when necessary, seek the advice of a qualified financial advisor or professional to ensure that any financial choices are appropriate for their individual circumstances.