Tax Diversification

Picture Courtesy of U.S. News

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When it comes to investing your assets, you have many options. Today let’s talk about options from a tax standpoint.

Typically when investing money, you can put your money in one of four baskets. For lack of being able to draw a picture for you, I’m going to spell out what that looks like.

Your first bucket is money that you invest that has never been taxed.  The money grows tax deferred meaning you don’t pay any taxes on the money until you take it out.  Once you withdraw funds from this bucket, every dollar you take out is taxed at your income level. Do you know what goes in this bucket? If you said 401k’s, Traditional IRA’s, 403B’s, 457 plans and qualified annuities, then you are right.

The next bucket contains money that has already been taxed from work.  Every year while the money grows you typically pay some type of tax. Then when you take this money out you again pay taxes.  This bucket would contain your brokerage accounts invested in mutual funds, stocks, and bonds. Savings accounts and cd’s are taxed every year, but not when you take the money out. 

The third bucket contains money that has already been taxed from work. The money grows tax deferred. And, when you take money out of this bucket, you pay taxes on all of the interest earned.  This bucket would contain your non-qualified annuities.  While I’m not a big fan of annuities, they can be a place to help get some tax deferred growth for our portfolios.

The last bucket is usually everyone’s favorite.  This bucket contains money that has been taxed once from earning it at work. Then the money grows tax deferred (again, you’re not paying taxes on it while the money is invested).  Then, unlike all of the other tax buckets, when you take money out of this bucket the money is tax fee.  Do you have any idea what goes into this bucket? The two main vehicles employed in this bucket would be your Roth Ira’s, 529 plans and Cash Value Life Insurance.  While Roth IRA’s are tax free upon withdrawal after age 59 ½, Cash value life insurance passes tax free on to your beneficiaries.  College education 529 plans must be used for college to achieve the tax free benefits.  While I didn’t include them exclusively inside of the bucket, municipal bonds also have a tax free component to them.

Taking a look at these four buckets, which bucket do think makes the most sense for your investment money? Like the hundreds of people I’ve walked through this illustration, you might be saying, give me the tax free money.  Logically, one would think it to make sense to invest in the tax free bucket. The problem is that investing solely in that bucket will not help you keep the most money in your pocket.  We’ve all hear the term diversification, but rarely have you heard of tax diversification.

Shortly put, we want to invest money inside of the buckets that make the most sense for you and your financial situation. You want to invest as much money as possible in each bucket that allows you to mitigate the tax risk associated with wealth accumulation.  By finding the right balance between all of the buckets, you allow yourself to keep your hard earned money in your pocket instead of unnecessarily forking it over to Uncle Sam.

At High Five Financial, these are the types of nuances we are thinking about when helping you “Plan With Purpose”.  I hope you found this information informative and helpful as you invest your hard earned dollars. 

Many Blessings,

Jose Cuevas
President & CEO
High Five Financial


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