Asset allocation usually gets most of the attention when it comes to diversifying clients’ portfolios. That’s understandable because allocation drives long-term portfolio results. Adequate diversification can also make it easier for clients to stay the course when market volatility spikes, as it has lately.
Tax diversification is another important planning strategy, however. Investment accounts fall into one of three tax categories: taxable, tax-deferred and Roth. Excessively overweighting one category or failing to diversify among all three can limit clients’ tax-planning flexibility.
It’s essentially a hedging strategy, according to Maria Bruno, senior investment analyst with Vanguard in Malvern, Pennsylvania. Tax diversification takes the same approach as asset allocation in that you’re diversifying taxes in light of unknown future income levels and tax laws. “By having the different buckets it gives the retiree the most flexibility to strategically spend down their assets in a tax-efficient manner,” she explains.
Many current retirees have large tax-deferred balances, a concentration determined largely by tax laws, she points out. Roth accounts weren’t available until the late 1990s and Roth conversions were limited until 2010. Consequently, retirees can find themselves facing sizable required minimum distributions (RMDs) at age 70 1/2, which could potentially bump them into a higher tax bracket.