Tax Strategy Diversification
The concept of investment diversification involves mitigating the risk of a catastrophic loss by owning numerous, low correlation assets. If capping exposure to a single security or asset class is wise because it effectively tempers investment risk, wouldn’t it also be wise to apply this principle to other hazards, like unknown future tax rates on income and gains? The first time I diversified my strategy to maintain core body temperature in the mountains by throwing a survival blanket in the backpack, it saved a dear friend’s life! Imagine a legislative scenario that exposes your lack of a tax strategy and begin diversifying exposure to one of ‘The Big Three’ risks against your retirement, your estate, and the future inheritance of your loved ones: the future tax hike.
I’d like to begin by identifying the potential pitfalls of the traditional retirement account because I believe most investors have allocated too high a percentage of their retirement savings to this “yet to be taxed” account type. Keep in mind this investment option also possesses significant advantages in many instances:
Since none of your traditional retirement plan dollars have yet been taxed, the IRS co-owns the account with you and can increase their portion with the stroke of a Congressional pen. The probability of this occurring, given the U.S. government’s indebtedness and the unfunded status of Social Security and Medicare, is higher than most people understand, including CPA’s.
All future withdrawals from traditional retirement accounts are taxed as income, in many cases resulting in a higher tax than the capital gains rate.
Fully income taxable Required Minimum Distributions (RMD’s) must be taken annually beginning at age 73 whether the income is needed or not, which pushes many large account holders into a higher bracket.
The Secure Act of 2020 imposed an account depletion requirement for non-spousal beneficiaries at 10 years from the original owner’s date of death; given the high probability your children will inherit your IRA during their peak earning years, this is a brilliant strategy by the IRS, your retirement account partner. You better have a strategy too!
Consider two attractive alternatives to the traditional retirement account, which are highly complementary when funded appropriately, given your individual tax situation:
The Roth IRA and/or Roth 401(k) effectively release the IRS from the partnership by virtue of the tax deferred growth and tax-free withdrawal benefits. Advanced planning software can effectively compare the Roth and Traditional options within your personal financial plan. The younger you are, the more likely the Roth option will benefit you more than the traditional option.
A non-retirement brokerage account differs from retirement accounts in that no legal contract is engaged with a fiscally reckless institution which can and has change(d) the rules in the middle of the game to its own advantage. Both gains and losses can be utilized annually to your tax advantage, even against assets not held in the brokerage account. There is no contribution limit, minimum withdrawal age, or mandatory distributions, and virtually any listed security is available. Penalty-free access to a potentially large amount of capital in a relatively tax-controlled distribution is a distinct benefit to investors.
Conrad Anker, perhaps the best technical climber in the world today, packed 200 pounds of exactly the right equipment to succeed in the First Ascent of Meru, formerly thought to be an unclimbable Himalayan peak. Effectively planning your retirement and ultimate estate distribution is equally complex, and the right mix of these three investment options can help you succeed. I strongly suggest that you introduce your fiduciary advisor, in an advisory relationship, to your CPA and have them work together for your tax benefit.
Think about it, Shaun.
“Give a portion to seven, or even to eight, for you know not what disaster may happen on earth.” ~Ecclesiastes 11:2
“The hardest thing in the world to understand is the income tax.” ~Albert Einstein
The opinions voiced in this material are general, are not intended to provide specific recommendations, and do not necessarily reflect the views of LPL Financial.
All investing involves risk including the possible loss of principle. No strategy ensures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
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