As you think about your savings, investment choices and market performance tend to dominate financial discussions; however, how and where you hold your money can also have a significant impact on your financial future. We focus so much on saving that sometimes you may not realize the tax burden that might await you in retirement.
Aiming to strategically allocate cash across different types of accounts—taxable, tax-deferred, and tax-free – can help manage tax liabilities now and in the future and can also provide flexibility when you want to access your money.
Tax diversification refers to spreading assets across different types of accounts that are taxed differently at withdrawal and provide different tax implications when contributing.
The three primary tax classifications for financial accounts include:
- Taxable Accounts: These include brokerage accounts and regular savings accounts where capital gains, dividends, and interest income are taxed annually. Long-term capital gains and qualified dividends are taxed at a lower capital gains tax rate.
- Tax-Deferred Accounts: Examples include traditional 401(k)s and IRAs, where contributions may be tax-deductible, and taxes are deferred until withdrawal. The assets held in this account will be taxed at your ordinary income tax rate when you withdraw the funds. Generally, you cannot access these funds without penalty until you are 59 ½.
- Tax-Free Accounts: Roth IRAs and Roth 401(k)s are funded with after-tax assets but allow for tax-free withdrawals in retirement.
Utilizing different account types can be beneficial for multiple reasons:
1. Provides Liquidity for Immediate Needs
Maintaining cash reserves and having assets in taxable accounts allows you to access funds without restrictions or penalties. Therefore, when an emergency comes, you’re less likely to be forced to withdraw from retirement accounts prematurely, which could trigger unnecessary taxes or penalties.
2. Helps Manage Taxable Income in Retirement
When funds are spread across taxable, tax-deferred, and tax-free accounts, you gain control over how much taxable income you generate in retirement. For example, if you withdraw from a Roth IRA instead of a traditional IRA, you can reduce your taxable income for the year while still covering your expenses.
3. Avoids Forced Withdrawals and Tax Surprises
Tax-deferred accounts like 401(k)s and traditional IRAs come with Required Minimum Distributions (RMDs) after a certain age. If all your funds are concentrated in these accounts, you may face higher tax bills in retirement. By keeping cash in a Roth IRA or taxable account, you can strategically withdraw from different sources to manage your tax bracket efficiently. This can also give you options when thinking about gifting in retirement by utilizing your RMD since other accounts can cover cash flows.
4. Enhances Estate Planning and Wealth Transfer
Tax diversification can also benefit your heirs. Roth IRAs allow beneficiaries to inherit tax-free funds, whereas tax-deferred accounts may lead to significant tax burdens. You may also utilize different types of accounts when leaving assets to charity – making sure the most tax-inefficient assets are left to charity.
Implementing cash across different types of accounts is a powerful yet simple way to enhance financial flexibility and tax efficiency. By strategically using taxable, tax-deferred, and tax-free accounts, you can work to minimize tax burdens, ensure liquidity, and create a more resilient financial plan. Whether you’re planning for retirement, preparing for economic uncertainty, or optimizing your estate plan, tax diversification through strategic cash allocation can be a fundamental step toward long-term financial success.
Would you like to refine your tax diversification strategy? Contact us for help tailoring a plan to fit your goals and risk tolerance.
