Tax Diversification refers to the strategy of spreading investments across different types of accounts that are taxed in various ways. This approach allows investors to manage their tax liability more effectively over time.
Tax diversification typically involves three main types of accounts:
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Taxable Accounts: Investments in these accounts are subject to capital gains taxes and ordinary income taxes as profits are realized.
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Tax-Deferred Accounts: Investments held in accounts like traditional IRAs or 401(k)s grow tax-deferred, meaning taxes are paid only when withdrawals are made, typically in retirement.
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Tax-Free Accounts: Contributions to accounts like Roth IRAs are made with after-tax dollars, but qualified withdrawals are tax-free.
By diversifying the types of accounts, investors can minimize their overall tax burden and have greater flexibility in managing withdrawals, particularly in retirement. For example, in years of high income, an investor might choose to withdraw funds from tax-free accounts to avoid increasing their taxable income.
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