Tax Diversification for Your Accounts

Hello, and thank you for joining me. There's a well-quoted saying by Nobel Prize winner Harry Markowitz that diversification is the only free lunch in investing. Professor Markowitz is correct. The path to investment success is through spreading your investments around, and continuing with the food theme, not keeping all your eggs in one basket. Today, I'd like to take that concept one step further and talk about tax diversification.

Investment diversification is the concept most of us are familiar with. It is how your money is invested, while tax diversification is where your money is located. And just as investment diversification is important when constructing a portfolio, the benefits of tax diversification have a major impact when constructing a long-term financial plan. Most often, there are three account types that each have benefits and trade-offs, with none being the clear-cut solution for all the different stages of your life.

First, pre-tax accounts. These are retirement accounts where you get an upfront tax reduction to your income for contributing. And during your working years, most likely your highest income years, you're not only reducing your current income, but sheltering taxes on the growth of your money as well. Later on, withdrawals are the inverse. Uncle Sam wants his take, meaning all the money contributed and its growth is taxed when taken out. Essentially, you know what you're saving in taxes when the money goes in, but you don't always know what you'll pay down the road when the money comes out, because both tax law and your own tax picture can change or differ from your working years to your retirement years. And this can be murky to plan around when looking at a multi-decade financial plan.

Which brings us to Roth accounts. These are retirement accounts where, rather than getting any current tax reduction, you make your deal with the IRS upfront and pay taxes on all the money you put in, for the trade-off of withdrawals being tax-free. Sounds like a no-brainer, right? Not always. Just like with pre-tax accounts, you want to thread the needle on the most favorable time to put money in these accounts, with the goal of paying less in overall taxes throughout your lifetime. Without an orchestrated plan, you could be paying too much in taxes upfront for withdrawals down the road. Roth accounts may have tremendous savings on your lifetime tax bill when strategically used in lower income tax years, such as a first job out of school, a sabbatical year or two mid-career, or in retirement, when your income tax picture can be shaped by you rather than for you.

Now, so far, we've just talked about retirement accounts, but there's life to be lived before then, which brings us to taxable accounts. These are the most flexible accounts to not only get money into, but get money out of as well. Anyone can put money in at any time, and anyone can take money out at any time, no age limits, contribution limits, or rules to plan around. So, what's the catch? Taxes the whole time. No deduction on the contribution, no tax-deferred growth or tax-free growth. Any dividends, interest, and capital gains are taxable throughout, all of which impact the growth of your portfolio if not planned for.

Now, why does this matter? Alone, any of the accounts work to help you build your wealth, but used together, well, they provide options and flexibility in a multi-decade financial plan that changes as your life does. Just like investment diversification provides a smoother ride along the way, tax diversification may work the same for you, smoothing out your tax bill with the goal of paying the least in lifetime taxes and providing you the ability to withdraw funds both during retirement and before, if needed.

So, in summary, before putting money away, think of it like this. Pre-tax accounts, to reduce your income on the front end. Roth accounts, to reduce your income on the back end. Taxable accounts, flexibility and access throughout. And just like other aspects of financial planning, what might make sense for someone in a given moment may not make sense for someone else. And your financial plan is going to dictate how to best leverage tax diversification for your personal situation. At Presilium, we evaluate these accounts for all of our clients, determining which are the most beneficial to contribute to or withdraw from annually, making opportunistic changes over the course of our clients' lifetimes, all in the name of developing a long-term financial plan that works both today and for years to come. Thanks for watching, and until next time.