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Is your portfolio taxwise?

Most people think of asset allocation as a diversification of asset classes, such as large cap stocks, small cap stocks and bonds. What they fail to see is that diversifying assets by taxability can also be important in building a successful financial planning strategy to last you both through your working years and into retirement.

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A portfolio that is well-diversified from a tax perspective can include a mix of:

  • Taxable investments: Examples include mutual funds, stocks and bonds, where taxes are paid on an ongoing basis;
  • Tax-deferred investments: This includes 401(k) plans, 403(b)s, traditional IRAs, deferred annuities and EE U.S. Savings bonds, where the investments can grow tax-deferred until distribution; and
  • Tax-free investments: Roth IRAs, Roth 401(k)s, 529 plans, municipal bonds and cash-value life insurance can provide tax-free income, when certain conditions are met.

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Investing assets among these categories can help create tax efficiencies within your portfolio while you're still earning a paycheck and throughout retirement.

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Here's one example: If you contribute money that has already been taxed to a Roth IRA during your working years, it will be allowed to grow tax-deferred as you continue to earn an income. You will also be able to take tax-free withdrawals when you decide to cash out in retirement (assuming all requirements are met).

In addition to offering diversification from other investments that receive different tax treatments—e.g., 401(k)s or traditional IRAs—this move may also be beneficial in managing your tax bracket in retirement, since money withdrawn from a Roth IRA generally does not count toward your taxable income.

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Knowing when and how to draw down different assets in retirement can be complex and is best determined in consultation with a tax advisor familiar with your unique situation. However, some basic principles may apply:

  1. First, consider the income you are already earning from your existing assets, including Social Security, if that applies.
  2. Next, look to see if you can take any long-term capital gains that would be taxed possibly at zero percent, depending on whether your total income for the year, including the gains, would be in the 10 percent or 15 percent brackets. Using this strategy can influence the next steps because adding more taxable income can move you into higher brackets.
  3. Then, figure out what your taxable income level is and what the top of your tax bracket is. This will help you calculate the room you have to take distributions from tax-deferred investments before you edge up to a higher tax bracket. This may be especially beneficial in years when your income is lower, so you can take full advantage of being in a lower tax bracket. Caveats do apply to distributions, especially if you are over 70½, so it's crucial when doing this type of planning to consult with a tax advisor.
  4. Then, assess the alternatives you have available to liquidate assets where all or most of the tax liability has been paid. If you need to offset capital gains from rebalancing your portfolio, consider liquidating capital assets that will either generate a capital loss or not generate an additional tax liability.
  5. Finally, leave your Roth IRA distributions for last. Since there are no required minimum distributions at age 70½, let this money grow tax-free for as long as possible. This would also hold true for accessing the cash value from a life insurance policy.
"A portfolio can benefit if it is tax-diversified as well as asset-class diversified. It may be better to start thinking about tax diversification sooner rather than later."

In addition to the above, you may want to consider some of the following issues.

  • Although emotionally tempting, it is not necessarily appropriate to pay off your mortgage as you near retirement—especially if you have a locked low interest rate and can benefit from the tax deduction while you are still working.
  • If your real estate taxes are high and your kids are out of school, you may want to consider moving to a lower tax area.

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Tax strategies vary from individual to individual and should always be planned with a tax advisor. The key message, however, is that a portfolio can benefit if it is tax-diversified as well as asset-class diversified. It may be better to start thinking about tax diversification sooner rather than later.

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