Tax diversification involves investing your money in places where it is treated differently. In other words, it leads to you paying less tax and gaining more money. Both are desirables outcomes. We are going to give you three ways in which you can easily add tax diversification to your portfolio.
After-Tax Holdings
The money invested has already been taxed, but any income you get from dividends will be taxed as income in the financial year you receive that money. These are basic investments and tax holdings, so this does not require more than a simple chat with your financial advisor.
Get them to choose the investments with specific rules related to lower tax rates, or preferably no tax rates at all.
Tax-Free Holdings
You pay no tax at all on these holdings. Again, this isn’t as complex as it sounds. The two most common tax-free holdings are Roth accounts and municipal bonds. They don’t offer massive rates of return, but they provide a way to save a significant amount of money for your retirement.
Tax-Deferred Holdings
You typically receive a tax deduction for contributions to accounts in this category. You only pay tax later on when you eventually withdraw.
So which accounts fall into this category?
These usually refer to contributions made to a retirement account, such as the 401(k), 403(b), and Thrift Savings Plan. Be aware that liquidity is minimal when you invest your money in this category of account.
On a final note, watch your liquidity. If you don’t have any liquidity, your choice of investment can actually hurt you.
Image credit: 401(K) 2012