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When we talk about diversification, there’s more to consider than just what mix of stocks and bonds you have in your portfolio. We also want to consider the type of accounts you have those assets in. Specifically, we want to look at how different investment accounts are taxed since this can help create opportunity and flexibility within a financial plan. This is sometimes called tax diversification.

How different investment accounts are taxed

With high-net-worth individuals, we primarily see two types of investment accounts—taxable accounts and qualified accounts.

Taxable accounts, like a standard brokerage account, don’t come with tax advantages. You contribute after-tax money (like income from your paycheck), and you pay taxes on any realized gains, interest payments, and dividend payments.

Qualified accounts—think 401(k)s and IRAs—may lower your taxable income because you can contribute pre-tax dollars. Plus, any gains, interest, and/or dividend payments accrue tax-free. The income tax bill comes later when you withdraw the money in retirement.

There’s a third category of accounts—Roths and 529s—that fit somewhere in the middle. These accounts are contributed to after tax, but the money in the account grows (realized gains, interest payments, dividend payments) tax-free. Many of our clients earn too much to contribute to Roth accounts directly, but when circumstances are right, we may recommend contributing to a Roth account via a conversion, sometimes called a backdoor contribution, to create more tax diversification.

What is tax diversification?

Ideally, you want to have your investments spread across all three types of accounts. Why? It’s great to have your investments grow tax-free like they do in a qualified account. Plus, if you’re trying to lower your taxable income in the present day, you may want to contribute as much as possible to a qualified account.

There are some potential negatives, though. For instance, you generally can’t withdraw money from a qualified retirement account before age 59½ without paying a penalty. Plus, qualified accounts trigger required minimum distributions (RMDs), and you must pay taxes on the income you withdraw in retirement.

It may be nice to give yourself the option, in retirement, of withdrawing money tax-free, like with a Roth account. Roth accounts don’t come with RMDs, either. (Both of these make Roth accounts a useful tool for estate planning if you’re planning to pass the account on to a family member.)

With taxable accounts, you can access your money at any time, but any money you make from the investments in that account may be subject to taxation. Taxable accounts are great for liquidity, and there are several tax-advantaged investments that make sense to hold in a taxable account. (Read more about how different investments are taxed in our article on tax location.)

In other words, each of these investment accounts can serve a purpose. When we create financial plans for clients, we aim to be strategic about the types of accounts used as well as the investments inside those accounts.

While Quorum Private Wealth does not provide tax advice, we do work closely with our client’s tax advisors to figure out a tax strategy that works holistically with a client’s goals—and that includes looking at the types of investment accounts. It’s all part of our mission to simplify, organize, and optimize.



Disclaimer: The subject matter in this communication is educational only and provided with the understanding that neither Sanctuary Wealth or Quorum Private Wealth are rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel, financial professionals, or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.