Having a solid financial plan isn’t about hitting the hot stock or timing the markets. It’s about organizing your assets in such a way that you have the flexibility to spend your money how you want to in the moment, while also continuing to build up your nest egg for later.

This type of flexibility in your retirement plan comes from a philosophy called tax diversification, and adhering to this philosophy can help you stay on track to work toward your goals, regardless of what’s happening in the markets.

Tax Diversification

To put it simply, tax diversification is the process of reducing your tax burden by distributing your assets throughout various investment accounts that are taxed in different ways. Similar to diversifying your investment portfolio, your goal here is to mitigate potential losses by not putting all your eggs in one basket. Applying this strategy to how your investment accounts are taxed, you can enact a plan to help reduce that tax burden.

For our purposes, tax diversification means splitting your assets into three different “buckets” of taxable, tax-deferred, and tax-advantaged investments:

  1. Taxable: Investments where any earnings are fully taxable at year-end.
  2. Tax-Deferred: You take a tax deduction today, but earnings grow tax-deferred, and taxes are deferred until distributions begin.
  3. Tax-Advantaged: Contributions are made after tax, they grow tax-free, and no tax is due on distributions—assuming certain requirements are met.

Again, the goal here is to mitigate your overall tax burden. So, this strategy helps you now by allowing you to receive deductions for some of these instruments. For example, in 2021, you may be eligible to contribute and deduct up to the limit of $6,500 to a Traditional IRA if you’re over age 50 or up to $7,550 for a health savings account (HSA).

It also helps you later by not having to pay taxes on the withdrawal of some funds because you’ve already paid tax up front. And for those funds you haven’t already paid taxes on, you may eventually pay a lower tax on them in retirement because you could be in a lower tax bracket.

Your Money Matrix™

At Wealth Enhancement Group, we have a proprietary tool called the Your Money Matrix to help you plan your long-term financial strategy. The Your Money Matrix also helps you understand your financial plan by applying your situation to this framework.

This strategy is represented visually by literally creating a matrix and strategically placing your assets within this matrix. To create the axes of the matrix, you need to think about your finances in two different ways: time frame and tax treatment, as shown in a simplified form in Figure 1 below.

Figure 1. Your Money Matrix

your money matrix

Time Frame

Group your money into short-, mid- and long-term time frames. In other words, group your money into what you think you’ll need in the short term (the next five years), the midterm (6–10 years), and the long term (10 years and beyond). This not only gives you a clearer picture of when you can expect to tap into these funds, but it also helps assuage the fears associated with higher-risk investing, because a longer time frame will likely provide enough time to absorb any market shocks (like the ones experienced in the 2008 recession and the COVID-19 pandemic).

Tax Treatment

This is where our previous tax diversification strategy comes into play. Funds in taxable investment accounts are completely liquid and easier to access, so these are funds you’ll likely want to save for the short term. You need ample taxable investments to meet financial needs occurring before age 59 ½, otherwise you’ll pay a 10% tax penalty if you take early withdrawals from tax-deferred or tax-advantaged accounts.

Tax-deferred accounts like Traditional IRAs, 401(k)s and 403(b)s offer immediate tax deductions and tax-deferred growth. But keep in mind that you must pay taxes when you eventually withdraw from these accounts, and required minimum distributions (RMDs) begin at age 72.

You’ll also likely benefit from a tax-advantaged Roth IRA, Roth 401(k) or HSA. You fund Roth IRAs and Roth 401(k)s with after-tax money, but your investments have the potential to grow tax-free, and there are no RMDs, so you’re in control of when and how much you withdraw. For HSAs, you get the double benefit of not paying tax on withdrawals for eligible medical expenses, as well as putting that money away tax-free.

Referring back to Figure 1, you can see where each of these types of investment accounts can fit inside the Your Money Matrix based on time frame and tax treatment. This enables you to plan how these funds can be used both now and in the future.

Work Toward the Flexible Retirement Plan of Your Dreams

Flexibility in retirement means being able to spend money however you want to now while still planning for the future. At Wealth Enhancement Group, we not only help to estimate your annual cash flow for a given year, but we also help you map out your investing strategy and categorize those investments according to tax-efficiency, which allows for more accuracy. By knowing what you have and how your accounts will be taxed, you can be more organized in your planning and future savings plans.

With a tax diversification strategy and the Your Money Matrix, you can plan for the future with the confidence that you’re ready for whatever life—and the investment markets—throw at you. Reach out to a Wealth Enhancement Group advisor to get started creating your own flexible retirement plan.

 

This information is not intended to be a substitute for a specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Ryan Marshall

Ryan Marshall

Vice President, Financial Advisor

Ryan’s experience in the wealth management arena is expansive, including working in trading and operations, financial analysis and planning. He’s accomplished in providing holistic financial advice to high net worth individuals and recognizes the importance of combining budgeting, retirement, investments, taxes and estate planning into a comprehensive wealth management strategy. Ryan’s very active and enjoys working out, skiing and anything outdoors. He resides in Stamford, CT. MSF, New England College of Business BA,...Read More