A Fruit Salad of Investments. An Orchard of Accounts.

One of my fellow CFP friends is fond of saying, “A diversified investment portfolio is like a fruit salad; you need more than just apples and oranges.”  As hokey as that sounds there is a cherry pip of truth in it.  A well-balanced, globally diverse mix of stocks, bonds and liquidity investments within your accounts guards against concentrated risk and smooths your path for long-term growth.

But consider another way to mix it up:  account diversification.  In today’s complex financial system, investors are wise to have both a variety of accounts and a variety of investments within those accounts to achieve their long-term goals.

So what’s the biggest payoff from account diversification?  You maintain flexibility and control over the income tax consequences that flow from the accounts when you make investment changes or take distributions.  Remember – it’s your money.  And anything you can do to minimize the amount of federal and state taxes you pay leaves more in your pocket.

Let’s take a look at the most common types of accounts in use today.  Many investors have the basics covered with after-tax savings (e.g., a checking, savings or investment account), an IRA and/or an employer-sponsored retirement account (e.g., a 401(k) or 403(b) plan).  Other key types of accounts in the diversification mix include a Roth (either a Roth IRA or Roth 401(k)) and a Health Savings Account (HSA).  If your goals include paying for a child’s education, then you may also be acquainted with a 529 Plan or even a Coverdell Education Savings Account.  Also in the mix are insurance-related accounts like annuities and whole life policies which build up cash value over time.  Some types of accounts are ideal for specific goals, others are general purpose.  Some types of accounts cause withdrawals to be taxed as ordinary income; some are taxed at capital gains rates; and some avoid taxation altogether.  It is the divergent tax treatment among these accounts that gives you the flexibility to control the outcome.

Over a 30-plus year time horizon, a household may have five or more different account types.  This can present a real challenge to optimize distributions to keep the tax bill low.  That’s where your Fiduciary Investment Advisor can help.  As trusted advisors and planners, our task is two-fold: 

1. Help you build wealth by directing funds into the right kind of accounts during your accumulation years
2. Help you maintain that wealth once you begin withdrawing from your accounts. 

Account diversification empowers you to pick and choose your tax consequences when it is time to rebalance your portfolio or take withdrawals.  In fact, account diversification gives you the control and confidence to make decisions that might otherwise seem counterintuitive.  Let’s explore. 

Conventional wisdom suggests you put off taking funds from your tax-qualified accounts, like IRAs, until the IRS requires you to do so at age 72.  But with account diversification you may instead layer your retirement income so that even in years before age 72, you withdraw from tax-qualified accounts if it leads to lower overall taxes.  Conventional wisdom suggests you use funds in your Health Savings Account annually to cover family medical expenses but with account diversification it may be more beneficial to use after-tax savings to pay for medical expenses, thus allowing continued tax-deferred growth in your HSA until well into retirement.  Conventional wisdom also suggests that you avoid incurring long-term capital gains from the sale of your after-tax investments until you need the funds.  But with account diversification and the right federal tax bracket, you may avoid capital gains taxes entirely when selling long-held investments -- even if you don’t need the sales proceeds immediately for spending. 

The power of account diversification goes beyond distribution decisions.  Younger investors accumulating wealth should add different types of accounts to their profile to take advantage of tax plays down the road and to help them get through unexpected tough times.  While we encourage investors to maximize tax-deferred contributions to retirement plans, IRAs and HSAs, don’t overlook the importance of after-tax savings.  If you lose your job and have to dip into savings to make ends meet, you would be better served by drawing from after-tax savings (which, at worst, may result in realizing capital gains) than by raiding an IRA or a 401(k) plan.  Remember that withdrawals from tax-deferred accounts before age 59 ½ may be subject to a 10% early withdrawal penalty, adding further cost to the equation.  Roth IRA withdrawals offer a little more flexibility in that you can always access your own contributions without consequence, but if you need to withdraw investment earnings prior to the Roth’s 5-year anniversary you may be hit with taxes and penalties.

Asset location is another important corollary to account diversification.  In general, it makes sense to place the least tax friendly investments in tax-qualified retirement accounts and the most tax friendly investments in after-tax accounts.  Fixed income investments which generate interest and dividends (taxed at ordinary income rates) are usually better placed in IRAs and 401(k) plans.  Stock investments which you intend to hold for a very long time may be better placed in after-tax accounts where, once sold, may generate gains taxed at lower rates.  Account diversification gives you the opportunity to better manage your annual tax bill by optimizing location.

Another strong argument for account diversification is that the future is simply unpredictable.  If past is prologue then it’s a safe bet that within the next generation we will see changes in the marginal federal tax brackets, changes in state taxation of retirement income, expansion or contraction of tax benefits associated with current retirement savings vehicles, or even the introduction of some completely new type of savings or retirement account.  Since 1996 we have seen the introduction of 529 Plans, Coverdell ESAs, the Roth IRA and 401(k) and Health Savings Accounts.  Who’s to say we have witnessed the end of such creative endeavors?  The prudent investor keeps his options open in anticipation of future changes.

When you and your advisor review your financial profile take a look at both your investment diversification and your account diversification.  Now may be the time to add other types of accounts to your current mix to enhance flexibility and advance your long-term goals.  As my fellow CFP friend might now say, in his own hokey way, having an orchard of fruit trees (i.e., account diversification) is just as important as the fruit salad itself.

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