Tax Diversification in Investing

by | Oct 28, 2024 | Resources

Tax diversification in investing involves spreading your investments across different types of accounts, assets, and securities to optimize tax efficiency. Here’s a breakdown of key strategies and concepts:

Account Types:

  • Taxable Accounts: Investments in regular brokerage accounts where you pay taxes on capital gains and dividends in the year they’re realized.
  • Tax-Deferred Accounts: Retirement accounts like Traditional IRAs and 401(k)s where you don’t pay taxes until you withdraw funds.
  • Tax-Exempt Accounts: Roth IRAs, HSA’s, 529 Plans, and similar accounts where investments grow tax-free, and withdrawals in retirement are also tax-free.

Asset Allocation and Securities:

  • Tax-Efficient Investments: Focus on investments that generate lower taxable income, such as index funds or ETFs, which typically have lower turnover and capital gain distributions.
  • Tax-Intensive Investments: Place high-turnover investments or those generating significant dividends (like bond funds) in tax-deferred or tax-exempt accounts.
  • Tax-Exempt Securities: Securities, like municipal bonds or US Treasury obligations, that are exempt from federal or state income tax are an option for taxable accounts.

Capital Gains Management:

  • Long-Term vs. Short-Term: In a taxable account, holding investments for more than a year qualifies for lower long-term capital gains tax rates, which may be less than ordinary tax rates. As long as owning a security aligns with your financial goals, consider delaying sales until one year after purchase.
  • Maximize Deductions and Tax Brackets: If you have excess deductions on your tax return, consider selling securities that have appreciated in value so the realized gain is offset by the excess deduction.  Also, work with your tax preparer or investment adviser to realize gains in the 0% capital gains tax bracket.

Tax Loss Harvesting:

  • Offset capital gains by selling underperforming investments at a loss. This can reduce your overall tax liability.
  • Beware of wash sales, selling a security at a loss and repurchasing it within 30 days.  The loss realized through a wash sale is negated, which may unexpectedly affect your income taxes.

Rebalancing Considerations:

  • When rebalancing your portfolio, consider the tax implications of selling investments in taxable accounts versus tax-deferred accounts.
  • When close to year-end weigh the benefit of delaying sales of securities until the subsequent tax year.
  • If you are charitably inclined, consider the benefits of a Donor Advised Fund and your ability to use it to tax efficiently rebalance an account.

Distribution Strategies:

  • Plan for withdrawals in retirement by strategically drawing from taxable, tax-deferred, and tax-exempt accounts to minimize tax impact over time.
  • Consider Roth IRA conversions in low tax bracket years.
  • If you are charitably inclined, consider the benefits of a Qualified Charitable Distribution from a Traditional IRA after age 70 ½.
  • Utilize the leftover balance in a 529 plan to fund Roth IRA contributions for the beneficiary.
  • Abide by rules that define a qualified distribution from a tax-deferred or tax-exempt account to minimize income tax as well as penalty.

Stay Informed:

  • Tax laws change frequently. Staying on top of changes can help you make informed decisions regarding tax strategies and your investments.