Question: I keep hearing and reading that I am supposed to be diversified in my investments. I feel dumb asking, but what does that even mean?
Answer: Last week we looked at diversification of the assets that make up your investment portfolio. That’s what most folks think of when the term “diversification” is used.
But though less-often discussed, no less important is diversifying the tax treatment of your investments.
So once you have a general idea of the way you wish to position and diversify your assets, you need to determine where you want them to reside.
For the sake of simplicity, here are the four basic types of accounts available to most individuals. Your situation will vary, so only use the following as a guide.
(1) Tax deductible / deferred accounts. These are generally referred to as retirement accounts. In a tax deductible / tax deferred account, contributions are made to the account with dollars that have not yet been taxed. In the case of a 401(k) or 403(b) retirement account, contributions are made directly from your payroll check before income taxes are deducted. In the case of a traditional individual retirement account (IRA), you may take an income tax deduction on your federal income tax return.
In both cases, you get a tax deduction in the year you make the contribution, your funds grow tax deferred while remaining in the account, and you will owe income taxes at whatever your particular tax rate is upon withdrawal at your retirement age. Beginning at age 70 ½, required minimum distributions must be made annually, according to an IRS formula.
Some individuals may find themselves in a lower tax bracket in retirement, but that should not be assumed. Individual circumstances will vary.
(2) Tax free accounts. This category would include Roth IRA and Roth 401(k) plans. Contributions are made post-tax (no deduction in the year of contribution). But the funds grow tax free while in the account. And if the funds remain in the account until the account holder is age 59 ½ or for five years (whichever period is longer), the funds may be withdrawn income tax free.
(3) Tax deferred accounts. Some individuals do not qualify for individual retirement accounts, either traditional or Roth. The IRS has income limits – if you make too much income in a given year, these attractive tax benefits are not offered to you in that year.
In these cases, contributions may be made to an IRA on a non-tax deductible basis so that funds may grow tax deferred. Income taxes will still be owed on the growth upon distribution (age 59 ½ or older).
Similar tax treatment may be achieved through the use of insurance company issued deferred annuities.
(4) Taxable accounts. These are simply investment accounts offering no special tax treatment. Contributions to such accounts are unlimited, but offer no special deductions for making the contribution. Each year, as the account grows, taxes are levied on the portion of the growth attributable to interest, dividends or realized capital gains. Taxes on each of these categories may vary in scope and amount, so special care should be exercised when calculating one’s tax liability from such accounts.
A word about income taxes. Will income taxes be higher or lower in your future? No one knows for sure. For this reason, it would seem to make sense to diversify not only your investment’s asset classes, but also its future tax treatment. This fundamental uncertainty about one’s future tax liability would seem to argue for a diversification in tax strategies as well. Combining one’s use of tax deductible, tax free, tax deferred and taxable accounts may be worth considering.
As always, be sure to discuss these options with a knowledgeable, licensed financial professional for the specific implications of your situation.
The future is unknowable. So not having all your “investment eggs” or “tax eggs” in one basket just seems to make sense.
That’s the essence of diversification.
Byron R. Moore, CFP® is managing director / planning group of Argent Advisors, Inc. Email him at email@example.com. Write to him at 500 East Reynolds Drive, Ruston, LA 71270 or call him at (318) 251-5800. The opinions of any single advisor do not necessarily reflect the opinions of Argent Advisors, Inc.No forecasts can be guaranteed. Argent Advisors, Inc. does not offer tax, insurance or legal advice. The information contained in this column should not be construed as a substitute for personalized investment, tax, insurance or legal advice.