If you've ever dipped your toes into the water of "personal finance tips," you've heard this one before: Don't put all your eggs in one basket. It's an idea that can be applied and is applicable across many aspects of our lives. I've uttered that phrase dozens, if not hundreds, of times when speaking to groups about managing their investments. This month, I'm focused on a different set of eggs ... eggs that can't be scrambled and can be tough to stomach: income taxes.
You could be confused at this point, wondering how you can put your "tax eggs" in different baskets when Uncle Sam is the recipient of all of our federal income-tax payments. While it's true we send taxes resulting from our investments to D.C., when, how and how much we send is largely impacted by the type of investment accounts we use. That's where the concept of tax diversification comes into play.
In practice, what it means is building a portfolio that includes taxable, pre-tax and potentially tax-free investment accounts. Let's look at three options you have to choose from as you build your own investment portfolio:
Pre-tax: This is where you'll find some of your classic retirement savings vehicles -- traditional IRAs, the Thrift Savings Plan (TSP) and other employer offerings like 401(k) and 403(b) plans. Other than the traditional IRA (which may or may not be tax deductible, depending on a couple of criteria), all of these plans reduce the taxes you pay today. That's because contributions you make to these plans reduce your income for tax purposes. Your investment in this type of plan is also tax-deferred. In other words, you pay no taxes on investment gains or income each year. Upon withdrawal, your contributions are generally subject to ordinary income tax. Although there are some exceptions, normally you are required to leave this type of account alone until age 59½; otherwise, any withdrawals may be subject to taxes and penalties. All in all, pre-tax vehicles are a great way to save on taxes today and build for retirement tomorrow.
Taxable: Here you've got investments and savings that are held outside any sort of IRA or retirement account. For example, a bank account (CD or savings), mutual fund or brokerage account you own individually or jointly with your spouse. You get no big tax breaks with this type of account and pay tax on investment income and gains as they are realized each year. However, you do get an investment vehicle with no strings attached. You can use the money when you want without fear of penalties ... although capital gains could be considered a penalty of sorts. What I like about this type of account is that you can use it for any goal you've got. It could be a down payment on a house next year or some "just-in-case" money for the kids' college. It also gives you a source of income in retirement that you can tap into with typically much tamer tax consequences than pre-tax-type vehicles create.
Tax free: Need I say more? Now we're talking about Roth -- Roth TSP, Roth IRAs, Roth 403(b) and the like. While contributions to any of the various Roth vehicles do not reduce your taxes today, they, too, accumulate over the years without taxes like the aforementioned pre-tax plans. The big benefit comes at retirement, when both your contributions and all the earnings can potentially be tapped without income tax. This can be especially beneficial if you end up in a higher tax bracket in the future. Also, with the Roth IRA (not the other Roth employer plans), you can access your contributions at any time without taxes or penalties, so that provides flexibility. Obviously, tapping a pool of money in retirement without tipping the tax scales even a tiny bit is an exciting option to build into your plan.
In the end, building a portfolio that includes all three of these types of "tax eggs" provides you with flexibility, control and options when it comes to how and when you access your money and pay your income taxes now and in retirement.
Too often, I've worked with folks who have done a great job of saving for retirement, but have done it all inside pre-tax accounts. For them, withdrawing funds becomes an antacid-inducing moment since every dollar they use represents a dollar of taxable income. So, a $5,000 vacation requires a $7,000 withdrawal in order to cover the taxes. That, in and of itself, can be taxing ... emotionally and financially.
So, if you're asked, "Roth, traditional or something else?" "Yes" could be a solid response as you eye your retirement homestretch.
