What is Tax Diversification?


Benjamin Franklin said that nothing is certain in life except death and taxes. But it was Will Rogers who added, “At least death doesn’t get worse every time Congress meets.”

When we invest we hear a lot about diversification (spreading risk by not having all of your money in one stock or sector) and asset allocation (spreading risk by not having all your money in one category such as US large stocks or foreign bonds). We also hear a lot about tax efficiency, especially in an environment of rising taxes.

Rarely, however, do we hear about tax diversification. Tax diversification is allocating your assets by the way your money is treated by the tax law. Most people will have three pools: taxable monies, tax-deferred monies, and tax-free monies. The vast majority, however, will end up with their assets mostly in one of these pools. Due to the prevalence of retirement plans, most will end up with a larger tax-deferred pool. Some, however, will end up with a larger amount in the taxable portion of their assets.

The neglected part seems to be the tax-free, especially if we don’t count municipal bonds. This is mostly due to the fairly recent advent of Roth IRAs and even more recent Roth 401(k). Now I know some people, many of whom are CPAs, are concerned about Roth IRAs because of the fear that Congress will end up taxing them anyway. While I don’t want to dismiss this concern, I believe the greater danger is missing the opportunity to have greater flexibility in one’s assets.

The great advantage of having some money in all three pools is that as tax regimes change, you have greater flexibility. Let’s pretend someone has 10% of their assets in the taxable pool and 90% in tax-deferred. Tax rates have gone up to 40% for their tax bracket. They don’t have too many options if they need to grab a large chunk of money for a new car or a lake house. To get $100,000 net out of their Traditional IRA they will have to take out about $167,000. Ouch.

But if they had their assets 30% taxable, 50% tax-deferred, and 20% tax-free, and the same scenario presented itself, they could just take the $100,000 from the tax-free pool. Better.

Since we don’t know what type of tax regime we will have in the future, prudence cautions to include tax diversification in investors’ financial planning.

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