Tax Diversification

Published by Robert W. Huntley, CFP®, CHFC®

We often talk about investment diversification. However, have you seen much discussion on tax diversification? Probably not.

Our tax system in the US extracts a heavy toll on earned income and ordinary income from savings and investments. Interest income, for example, is taxed as ordinary income. If you have cash in the bank paying you interest, you receive a 1099 each year showing you how much interest you earned and that goes directly onto your tax return to be taxed at the rate you’re paying on your W2 earned income.

That tax toll can be as high as 38% depending on your income.

We defer income in many ways, but the most popular, for most people, is by using company savings plans such as 401k and 403b plans. IRA’s are also a popular way to defer taxes earned on your savings and investments, so long as the money stays in these plans you don’t have to pay tax on that money.

When you begin taking distributions, 100% of that money goes onto your tax return as ordinary income. You pay tax on all of it.

The IRS requires you to start taking it out when you turn age 70 1/2. Even if you don’t need the income, you still must begin taking distributions.

TAX DIVERSIFICATION – So what does it mean to use tax diversification?

Wouldn’t it be helpful to have different pools of invested money that allow you to control how much taxable income you report each year during retirement? That would be ideal because some years you might be fine with adding some more ordinary income.

Other years you might prefer not to. Having options is a good thing, but how do you do that?

A FEW OPTIONS – Tax-free income is possible.

  1. ROTH IRA’s – These accounts allow for tax-free growth and tax-free withdrawals. They also are not subject to age 70 1/2 Required Minimum Distributions.

Imagine having a good chunk of money in Roth IRA’s so you could choose whether to take money to purchase that new car and pay no tax versus taking the money from other sources that are taxed.

Some years might make more sense to pay the tax due to low income and tax rates. Other years, perhaps not. That is tax diversification.

2. MUNICIPAL BONDS – These generate tax-free We like using laddered Municipal Bond strategies to minimize interest rate risk. High net worth investors have used municipal bonds for years to park money in a stable place and avoid income tax completely on the interest received.

3. LIFE INSURANCE CASH VALUES – We don’t view life insurance as an investment, but it cannot be denied that cash building up inside a life insurance policy is highly favored under current US tax law. Any gains inside the policy are tax-deferred. Death benefits are tax-free, and as a source of income or money on demand, these policies have a couple of other advantages:

First, you can withdraw your contributions to the policy first before getting into any deferred earnings, so FIFO treatment (First In First Out) lets you make withdrawals on the principal first that isn’t taxed.

Second, you can borrow against otherwise tax-deferred earnings in the policy and receive tax-free amounts in the form of policy loans. However, take caution on these policy loans; we too often see people with loans on these policies that are too large and threaten to lapse the policy. That can be a big mistake, so caution and expert help are recommended.

CONCLUSION – When we talk about tax diversification, these scenarios are what we’re referring to. It’s great to have a pile of money in IRA’s and your 401k plan, but if you must pay income tax every time you take withdrawals, that can be inflexible.

Our ideal plan for clients is to have some money in other tax-free accounts that allow for some flexibility on what tax treatment you want to trigger when you take withdrawals.

Something to think about! Remember, you don’t have to be the library, you only need to be the librarian. We are here as your resource to help solve intricate problems and make the complex simple.


Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

Investors should consider their investment objectives, risks, charges and expenses associated with municipal fund securities before investing. This information is found in the issuer’s official statement and should be read carefully before investing.

The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable by having the policy approved. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications.

For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give legal or tax advice.





Get in Touch

In just minutes we can get to know your situation, then connect you with an advisor committed to helping you pursue true wealth.

Contact Us

Stay Connected

Business professional using his tablet to check his financial numbers

401(k) Calculator

Determine how your retirement account compares to what you may need in retirement.

Get Started