One of the keys to successful investing is diversification. This strategy involves building a portfolio of stocks and bonds with the purpose of minimizing risk while minimizing declines and maximizing gains. For years this time-proven method of asset allocation has been the cornerstone of investing. However, there is also another type of diversification that needs to be employed at the same time. It is tax diversification. Tax diversification involves building a portfolio of investments and accounts that are taxed differently. The purpose is to minimize tax risk by preventing an investor from paying too much much in taxes and thus keep more of their income.
Investments and Accounts can potentially produce three types of income. These types are ordinary income, capital gains income, and tax-free income. The first two are taxed differently depending on your federal income tax bracket; they will influence how much tax-free income you will need to offset your ordinary income tax and capital gains tax. Tax diversification is often overlooked but in this political atmosphere in which some government officials wish to raise taxes, it is more important to understand how to spread out your income.
Ordinary Income taxes are the most common type. Anyone who earns a salary or wage pays ordinary income taxes. However, your investments and accounts also pay ordinary income which is taxed at your federal and state income tax rate. One source of ordinary income is distributions from retirement accounts. When a retiree reaches age 70 ½ he/she is required to begin taking required minimum distributions (RMD). These distributions and only these distributions are taxed. Another source of ordinary income is the dividends produced by investments inside a brokerage account or a non-qualified annuity with a life insurance company. In addition, interest-paying bank accounts and certificate of deposits are taxed as ordinary income.
Capital Gains are another type of taxable investment income. The most common capital gains occur when an investment or property is sold at a profit. Capital Gains are taxed at a lower rate than ordinary income and in some instances, depending on your salary, are not taxed at all. Other types of income taxed in this manner are mutual fund capital gains and stock dividends from company stocks held more than 60 days prior to the ex-dividend date.
Tax-Free Investment Income is the favorite of most. Investments that pay income which is not taxed allows the payee to keep all of it. Distributions from retirement accounts such as the Roth IRA and Roth 401(k) are tax-free as long as the account has been open more than five years. In addition, distributions from 529 College Savings Plans are tax-free. Interest paid by municipal bond from your home state is also tax-exempt. Dividends from tax-exempt bond funds and ETFs fall into this category as well. Finally, the cash value inside permanent life insurance policies and dividends from participating whole life insurance policies are not taxable.
As Ben Franklin said, “in this world, nothing can be said to be certain, except death and taxes”. Unfortunately, no truer words have been spoken. However, by diversifying your investment income, it can be possible to minimize your tax risk. While we cannot avoid taxes, we can plan for them. An Advisor and a Tax Professional will work with you to devise a plan to help you keep more of what you make.
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Matt Dressel is the Owner of the Independent Financial Solutions Group, a Registered Investment Advisor. He is an Investment Advisor and Life & Disability Insurance Agent. He can be reached at 252-515-0242 or matthewdressel.ifsg@gmail.com. Securities are offered through Trade PMR, Member FINRA/SIPC. This article is not to be construed as tax advice.
