Diversification Isn’t Just About Stocks: Why Tax Buckets Matter
Greetings!
This week, I wanted to take the opportunity to reflect on the concept of “diversification” across different types of accounts. In other words, instead of thinking about asset allocation, I want to consider the importance of asset location.
Diversification Isn’t Just About Stocks: Why Tax Buckets Matter
When people think about diversification, they usually focus on spreading investments across different sectors or different asset classes—stocks, bonds, real estate, maybe even some alternatives. But if you stop there, you’re missing a key part of long-term financial success: tax diversification, especially if you’re heading into retirement and are starting to consider drawing from various accounts.
Tax diversification means spreading your money across different types of accounts— taxable, tax-deferred, and tax-free—so you have flexibility in more than just your aching hips through retirement. Here’s why this matters:
1. Control What We CAN Control
If all your money is in tax-deferred accounts like a 401(k)s or traditional IRAs, every dollar you withdraw in retirement is taxed as ordinary income. Not ideal. But if you have a mix of tax-free (Roth IRA, Roth 401(k)) and taxable brokerage accounts, you can strategically withdraw from different buckets to keep your tax rate low. Note: even though everyone and their cousin praises tax advantaged accounts, just remember the taxable brokerage account is also tax advantaged as you get to pay cap gains taxes vs. ordinary income taxes.
2. Hedge Against Future Tax Changes
Even though insurance agents take every opportunity they can get to convince you that taxes are only going up for you always and forever, nobody knows where tax rates will be in 20 or 30 years, nor do most people have a clear picture of what their personal tax bracket might look like. So by diversifying across tax treatments, you won’t be at the mercy of government policy or pure chance. If tax rates rise, you can lean on tax-free accounts. If they drop, you might take more from tax-deferred accounts.
3. More Flexibility for Early or Late Retirement
Some accounts have early withdrawal penalties (like 401(k)s before age 59½), while others, like Roth IRAs, allow you to access contributions any time. Having different account types gives you options, whether you want to retire early, delay Social Security, or just smooth out your income over time. I mandate that clients at least think about why they wouldn’t have assets in every single type of taxed account out there, so they can always have the option. We like options!
Bottom Line
Just like you wouldn’t put all your money in one stock, you shouldn’t put all your money in one tax bucket. Building a mix of taxable, tax-deferred, and tax-free accounts gives you control, flexibility, and peace of mind in retirement.
As always, hope this proves somewhat thought-provoking, and appreciate your taking a few minutes to read.
Tyler
