You might not be used to thinking of your investments in terms of taxable, tax-deferred, and tax-free. Learn why you might want to..
Diversifying your investments involves spreading your risks by investing in a variety of asset classes such as stocks, bonds, commodities, and real estate. But with a changing tax landscape, you might consider three more classes: taxable, tax-deferred, and tax-free.
Years ago, taxpayers often worked under the assumption that their tax bracket would be lower after they retire. Therefore, a common strategy was to defer as much taxable income as possible to the golden years. Now, however, with the possibility of higher tax rates in the future, it could be more efficient to pay those taxes today while rates remain lower. Since no one knows for sure what Washington will do, it might be time to hedge your tax risk and allocate your portfolio between accounts with differing tax consequences.
• Taxable accounts, such as savings or brokerage accounts, result in current taxation on earnings, but they also provide maximum flexibility. You can withdraw as much as you wish whenever you wish, with no IRS penalties. Keeping some of your nest egg in this type of account will provide immediate funds for major purchases, debt reduction, or emergencies.
• Tax-deferred accounts, such as IRAs or 401(k)s, only postpone the payment of taxes; eventually you will have to pay Uncle Sam when you withdraw the funds. But in the meantime, you generally receive a current-year tax deduction when you contribute, and the account can grow tax-deferred until you take it out at retirement.
• Tax-free accounts, such as Roth IRAs, are funded with after-tax dollars. What you put in, including any investment earnings, can be later withdrawn tax-free. The downside? You generally must wait until after age 59½ (and the account has to be open for five years) to make a tax-free withdrawal.
Diversifying your portfolio is only the first step. The next (and trickiest) step is properly investing in each tax class. For instance, your goal for a taxable account might be to generate growth while keeping taxable earnings to a minimum. This could be done by investing in tax-exempt municipal bonds or low-dividend yielding growth stocks.
In a tax-deferred account, investment income is not taxed until withdrawn, so earnings can come from any source without immediate tax implications. However, since you must start withdrawing funds from an IRA or 401(k) at age 70½, you might want to consider this in your planning.
Tax-free Roth IRAs offer the longest time horizon for investing since you are not required to make a withdrawal at any age.