Are you familiar with the old adage “Don’t put all your eggs in one basket?” This phrase is often used to reinforce why it’s important to diversify your investments to help reduce the risk of losses.
But the wisdom of diversification extends beyond retirement savings, too. Did you know it’s also wise to apply this principle to your tax strategy? You can position the money you’re saving (or have already saved) to be more income tax-efficient by allocating your assets across three buckets: tax now, tax later, or tax never. Doing this can potentially increase your total spendable income when you need it most.
Below is a quick guide to help familiarize you with the different tax buckets.
1. Tax now: These are the savings accounts where any potential interest, dividends, and gains that you earn are taxed immediately. Typically, accounts like checking, savings, certificates of deposit, and mutual funds are in this category. While these gains are taxed annually, both the contributions and potential gains are readily available for a rainy day. The money in many of these accounts also doesn’t fluctuate with the market.[1]
2. Tax later: Money in these accounts, which includes 401(k)s, 403(b)s, and traditional IRAs, are funded with pre-tax dollars and can grow tax deferred. This means you pay the income tax on both your contributions and any potential gains when you withdraw the funds. These assets are generally earmarked for longer-term needs, like retirement and college funding.[2,3,4]
3. Tax never:[5] Roth IRAs and Roth 401(k)s,[6] municipal bonds,[7] and life insurance with cash value[8] are the most common accounts in the tax-never basket. With these accounts, the gains you may get may not be taxed – you generally don’t get taxed annually and you may avoid taxation when you take the money out.
Want to get started? A good first step is to meet with a financial professional to go over your savings accounts. They’ll ask about your objectives, learn about your risk tolerance, and help you develop a strategy that ensures your investments are in the appropriate types of accounts.
As you consult with your financial professional, you may also want to ask them about the tax implications of individual stocks, Roth conversions, Social Security, and estate planning. Depending on the complexity of the tax questions you’re dealing with, you may need to reach out to a tax advisor for additional guidance.
Whether you’re just starting in your career, planning for the future, or already in retirement, thinking about tax diversification is important. Having a thoughtful strategy will help ensure you can get the most out of the assets you’ve worked so hard to earn so you can live a life of meaning and gratitude.
This article was prepared by Thrivent for use by Eagan City Lifestyle by Josiah Parker, Financial Advisor, and Jeremy Jackson, CIMA®, FIC, Wealth Advisor. Josiah can be reached at 612-990-4125 or Josiah.parker@thrivent.com. Jeremy can be reached at 763-330-2905 or jeremy.jackson@thrivent.com. You can also visit their website at https://connect.thrivent.com/pattern-wealth-group.
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1 Any interest, dividends or capital appreciation is subject to taxation when realized.
2 Gains subject to income tax when withdrawn.
3 Generally funded with pre-tax dollars.
4 Distributions prior to age 59½ may incur a 10% premature distribution penalty.
5 The withdrawal of dividends or the amount of a loan or partial surrender may be subject to ordinary income taxes.
6 Funded with after-tax dollars, qualified distributions of gains are penalty and tax-free.
Non-qualified distributions prior to age 59½ may incur a 10% premature distribution penalty; all distributions may incur surrender charges.
7 Interest is free from federal income tax; may be subject to state income tax, federal alternative minimum tax and capital gains tax.
8 The primary purpose of life insurance is for the death benefit protection. Withdrawals may be available income-tax-free to the extent of basis. Lifetime distributions of the cash value are subject to possible income taxation and penalties, could reduce the death benefit, and could cause the contract to lapse.
While diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market. Funded with after-tax dollars, qualified distributions of gains are penalty and tax-free. Non-qualified distributions of gains prior to age 59½ may incur a 10% premature distribution penalty and are taxable. Thrivent financial professionals have general knowledge of the Social Security tenets. For complete details on your situation, contact the Social Security Administration. Thrivent and its financial professionals do not provide legal, accounting or tax advice. Consult your attorney or tax professional.
Thrivent is the marketing name for Thrivent Financial for Lutherans. Insurance products issued by Thrivent. Not available in all states. Securities and investment advisory services offered through Thrivent Investment Management Inc., a registered investment adviser, member FINRA and SIPC, and a subsidiary of Thrivent. Licensed agent/producer of Thrivent. Registered representative of Thrivent Investment Management, Inc. Advisory services available through investment adviser representatives only. Thrivent.com/disclosures.
