Tax Diversification…What Is It?
by Ashby Daniels |
Most people are familiar with the term diversification. Simply stated, it means not keeping all of your eggs in one basket. Most federal employees relate diversification to how their Thrift Savings Plan (TSP) investments are allocated, meaning spreading the total account value among large cap funds (C Fund), small cap funds (S Fund), international investments (I Fund) and some fixed income funds (G and F Funds). Doing this ensures that they’re keeping at least a portion of their investments within the best performing asset classes, and at no point are all of their investments within the worst performing class. So, what does this have to do with taxes?
Tax diversification is a similar process. It’s the strategy of investing your dollars in assets that are treated differently from a tax perspective. Let’s look at the three types of investments.
- Taxed investments: These are investments like single registered and joint registered mutual fund accounts, and owning individual stocks. You pay taxes on the capital gains and dividends at the end of the year or on an as-you-go basis.
- Tax deferred investments: This is your TSP. Essentially, you’re reducing your tax liability in the current year by deferring your income to a later date, when your marginal tax bracket will determine the taxes owed on those distributions.
- Tax free investments: An example of a tax free investment is a Roth IRA. This is where all qualified distributions (distributions taken at age 59½ or older), including both principal and account growth, are distributed to you free of taxes.
So, what’s the big deal? Regardless of your age, you should consider how to withdraw money from your retirement accounts, while making the most of your dollars. When it’s time to create a withdrawal strategy, you’ll need to consider how the withdrawals are taxed so that you take the least possible amount while paying as little in taxes as possible. Based on these tax rate assumptions, you’re likely to project the smartest way to build your income stream.
If you’re early to mid-career, establish your distribution strategy as early as possible so that you’ll know what type of investments you should be taking advantage of right now. This will go a long way to ensuring flexibility and stability in your retirement plan.
If you are nearing retirement or have already retired, put your plan together so you know from which account your money is being distributed. In the past few years, I’ve had more and more feds tell me that they want to wait as long as possible before accessing their TSP. But, instead of focusing on when to distribute each piece, consider what will make your money last the longest while paying the least in taxes.
This may sound complicated. The typical thought pattern regarding retirement accounts is that one should take distributions from taxable accounts until depleted, then from tax-deferred accounts, and finally from a Roth in order to let the dollars grow as long as possible. In reality, you’ll basically be playing a game against your respective marginal tax bracket. It’s also important to re-evaluate your sources of income annually to determine how you should receive income to make the most of your hard earned retirement accounts.
The ultimate goal is to have a stress-free retirement by making your money last. You’ll want to maximize your investment accounts throughout your retirement, so, you must have a good understanding of the effect that taxes will have on your retirement.
How do you do this? The answer is that your situation is very different from everyone around you. You have different goals. You have different retirement account values. You have different Social Security and pension amounts. There is an optimal retirement income strategy for you. Have you figured out how to make your income last?
© 2013 First Command Financial Services, Inc., parent of First Command Financial Planning, Inc. (Member SIPC, FINRA), First Command Insurance Services, Inc. and First Command Bank. Financial planning services and investment products, including securities, are offered by First Command Financial Planning, Inc. Insurance products and services are offered by First Command Insurance Services, Inc. Banking products and services are offered by First Command Bank. In certain states, as required by law, First Command Insurance Services, Inc. does business as a separate domestic corporation. Securities products are not FDIC insured, have no bank guarantee and may lose value. A financial plan, by itself, cannot assure that retirement or other financial goals will be met.
by Ashby Daniels |