The Importance of Tax Diversification

John Boardman

When most people think of diversification, they primarily focus on a proper mix of portfolio assets.  As we have noted in the past, we target an asset mix of non-correlating assets for our clients.  This could include stock, exchange traded funds, mutual funds, REITs, etc.  However, one area of diversification that is often ignored is Tax Diversification.  As people accumulate all types of assets (retirement, real estate, business, etc.), it is vital to understand how each asset will be treated now and in the future.  By owning assets across the varied tax treatments, an investor creates a great deal of flexibility.

As a consistent practice, we analyze how changes in tax rates could affect that person or family’s plan. In the last twenty years, we have witnessed several major tax law changes and it would be irresponsible of us to not consider how future changes in tax laws (even very minor changes) could alter someone’s plan. We have found the best solution for a nimble financial plan is the accumulation of financial assets in a wide array of “tax buckets.” Looking at the wide-array of tax types available, an investor could own tax-deferred (IRA, 401k, etc.), tax-free (Roth), tax-free income (Municipal bonds), Non-qualified tax deferred (annuity), non-qualified (Individual or Joint), or life insurance that can sometimes be borrowed from tax-free. For clients drawing an income, it is always best if they have several types of “tax buckets” because that provides us ultimate flexibility in structuring an income stream that optimizes current tax laws.  After someone reaches age 72, investors are required to take distributions out of all tax deferred retirement plans.  With proper planning and tax diversification well in advance of this occurrence, we can mitigate income tax liability by structuring income in the most efficient manner possible.

One of the most difficult tax situations to predict is the impact of estate or inheritance taxes on someone at death.  Since 2000, we have seen the tax free amount you can pass to the next generation change from $1 Million to $3.5 Million to unlimited and now increased to over $11 Million per person. How in the world can you prepare for that kind of change? The estate tax has been a particularly common hot-button issue between Republicans and Democrats. Ironically, the estate tax generates a relatively insignificant portion of tax revenues (only 0.7% of tax collected in 2013 per the Center on Budget and Policy Priorities). Politicians have continued to fight over the level of the tax because it is, in my opinion, a primarily symbolic tax. The best plans we construct are those that consider how extreme law changes could impact a person’s estate plan. We do a lot of “plan for the worst but hope for the best” in this business.  Various asset types can be treated very differently when passed to survivors.  Some assets receive basis step-up (cost basis for inheritors is value at date of death) while some do not.  As well, certain assets like life insurance can be excluded from estate taxes if properly planned.

Proper tax diversification also provides a great deal of flexibility.  When people sell their business or retire, they often make major financial decisions soon after.  These decisions could include paying off their house, buying a second home, starting a charitable fund, or making major gifts to family.   For investors who have solely relied on tax deferred savings (i.e. 401k’s), they will face huge tax payments for major distributions as all of these distributions are added to their annual income on their 1040.  With non-retirement savings, Roth retirement accounts, or even accumulated cash values in life insurance policies, a person would have many more tax efficient account types to draw from.

The most important theme of this commentary is to not assume that tax rates will remain constant over time.  When we look over a time horizon of over twenty or thirty years, we have to assume tax rates will likely change multiple times.  It is also never too early to address this area of your plan as accumulation across various “tax buckets” can take a considerable amount of time.