Tax diversification is a strategic approach to managing investments by allocating funds across various types of accounts to maximize tax efficiency and hedge against future tax rate fluctuations. This strategy, often referred to as asset location, involves choosing the right types of investments for different account types to maximize their tax advantages. An individual’s asset allocation should be based on each asset’s after-tax value.
There are primarily two types of investment accounts: taxable and tax-deferred (more in chapter “Tax Advantaged Accounts”). In taxable accounts, such as regular brokerage accounts, investments are not tax-deductible, and gains are subject to taxes on dividends and capital gains during the year they are realized. On the other hand, tax-deferred accounts, like traditional IRAs and 401(k)s, allow investments to grow without immediate tax implications, and taxes are only paid upon withdrawal.
Diversifying your investments across different account types, including Roth IRAs, traditional IRAs, and 401(k)s, can help manage risks associated with tax rate changes. For instance, Roth IRAs offer tax-free growth and withdrawals, which are particularly advantageous if tax rates are expected to increase in the future. Conversely, traditional IRAs and 401(k)s provide immediate tax deductions, which can be beneficial if your current tax rates are high.