Diversification is commonly thought of as owning different investments. There is also the notion of not having all your money in one place or investment account. Diversification even occurs in alternating exercises or eating different food types. The concept has benefits and overlooked consequences.
The most overlooked diversification that we observe in dealing with families preparing for retirement is in the form of future taxation. There are three ways income can be taxed when you retire, generally: your marginal rate; long term capital gains and qualified dividends rate; and tax-free.
The best way to think about your taxable income is the amount of all your income less the standard deduction or the amount you can itemize. That will be found on line 10 of your tax return starting in 2018. The taxes you pay then progress to higher amounts similar to staircases going higher with each step. The more income you recognize, the higher the percentage you pay. Each step is known as a bracket in tax talk.
The first step is taxed at 10% followed by 12% and then 22%. The staircase currently goes all the way to 37% at higher incomes. The amount on the top step was 70% when Regan took office in 1980. The percentages on the stair steps do change, but the concept does not. Your marginal rate is based on your personal “highest step.”
Long term capital gains and qualified dividends are taxed at preferential rates meaning lower than your marginal tax bracket. If you are in the 12% bracket, including capital gains and dividends, your taxation on those two income sources is currently 0%. Higher steps also get a break with the top long term capital gains rate at the federal level being 20%.
Tax-free income is derived from Roth IRA and 401(k) contributions and growth from previous years. If your tax brackets are managed correctly, then you can also have long term capital gains and qualified dividends that can be tax-free as well.
The majority of families we meet are not tax diversified. They have invested their hard-earned income in tax-deferred investments with little to any in tax-free Roth’s or accounts that can generate long term capital gains and qualified dividends.
There are CPAs and investment arguments that contend it doesn’t matter if you do a Roth IRA or a tax-deferred IRA the same result will occur years later. This is a poorly conceived argument and presumes tax rates don’t change for the nation or the individual. Tax diversification provides options to control the amount of taxation you will recognize at retirement.
Retirement is the switch from paying attention to your total assets to being concerned with your taxable income. Success is contingent on replacing your standard of living (not a percentage of your income) after the IRS gets their share.
You can create a tax diversified strategy that provides choices for your retirement income stream. Start now and remember that diversification matters.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see our Disclosure page for the full disclaimer.