Is your investment portfolio tax-diversified? | Company

I’ve written many times about the value of keeping your investment portfolio well-diversified across many investment asset classes. But diversifying your income tax portfolio can also be a valuable way to maximize the wealth you keep and pass on to your heirs.

Here’s a high-level explanation of how it works.

Most taxpayers have access to three types of investable savings accounts: those that are taxable annually, such as brokerage accounts and bank accounts; those that are tax-deferred until retirement, such as 401(k)s and IRAs; and Roth accounts that are tax-exempt for life.

At the same time, different investments have different tax treatments. Gains on individual stocks, for example, are not taxed until the stocks are sold – and potentially at a lower capital gains tax rate. Bonds regularly generate taxable income whenever interest is paid and, with the exception of certain types, tend to be less tax efficient. Taxes on certain distributions from real estate investment trusts are deferred until the shares are subsequently sold. Gold and silver investments are taxed at a higher capital gains rate than other investments when sold.

The fact that no one has any idea what income tax rates will be in the future complicates the challenge of tax minimization. Since the passage of the Tax Cuts and Jobs Act in 2018, federal income tax rates have been among the lowest in decades. While this suggests that rates are more likely to rise rather than fall in the future, potential future political and economic events reduce any predictions made today to little more than pure guesswork.

Diversification

What is the best way to tax diversify your portfolio? During your working years, try to keep some of your savings in all three types of accounts. In your taxable accounts, try to maintain at least enough to cover all annual spending needs. Due to the uncertainty of future rates, a good approach is to develop a multi-year plan where tax-free savings are increased during low-income years and vice versa (subject, of course, to the various cap rules contribution). During the years between retirement and age 72 – before the required minimum distributions begin – building your accounts tax-free (for example, via Roth conversions) can be particularly effective.

Next, focus on the investments in each account. In general, plan to place (buy) the most tax-efficient investments, such as stocks or equity funds, in the least tax-efficient accounts and the least tax-efficient assets ( such as bonds) in the most tax-efficient accounts. But you still need a mix of asset classes in taxable accounts. Otherwise, every time you rebalance those accounts, you’ll be forced to pay the higher taxes you were trying to avoid.

Good asset location is an art, not a science. Also be aware that after retirement you will likely need to change your tax allocation strategy, as you will be taking more out of your portfolio than you are adding to it.

Optimizing tax diversification over time is one more technique you can add to your investment strategy to increase your lifetime savings. Remember though that asset class diversification is always more important than tax diversification. In other words, “Never let the tax tail wag the investment dog.”

A Los Altos resident, Artie Green is a Certified Financial Planner and founder of Cognizant Wealth Advisors. For more information, visit cognizantwealth.com.

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