Tax Diversification - Invest in these 3 Tax Buckets

Hey what's up everyone and welcome to the School of Personal Finance. In today's video we're going to be talking about tax diversification. Now I call this the secret sauce when it comes to paying the least amount of taxes throughout your lifetime while also maintaining maximum flexibility in case you do want to enjoy some of this money before age 59 and a half. So I'm going to explain exactly what I'm talking about. I'm going to show you a couple examples so that you could apply this All right let's get to it. All right so a few quick things. The first one is I just started a lean keto diet. So I'm throwing this out there to hold myself accountable. Hopefully over the next few months you'll start to see me get a little bit skinnier. I mean I never lost the quarantine weight that I put on, the 20 pounds or so that I put on during 2020. So that's the goal, lose 20 pounds. We'll see how I do with that. The other thing is go check out School of Personal Finance. Come join my education center. It's going to be awesome. I would love for you to be a part of it. Asset allocation is a term that we are all very familiar with. We all know the importance of having a well-diversified portfolio, of investing in stocks, bonds, mutual funds, ETFs, real estate, crypto. All of these things make up a well-rounded diversified portfolio. But what we don't hear talked about very often is the importance of tax diversification. So when it comes to taxes there are three different buckets I like to call them. The first one and the one that most people invest a large portion of their money in are tax deferred types of accounts. So that is going to be your traditional IRA or your 401k. These are accounts where you get a tax deduction to put the money in to those accounts. So you get a nice little tax break in the year that you make the contribution. And then the money inside of those accounts, it grows tax deferred all of those years. And then in retirement after the age of 59 and a half, when you take the money out, that is when you pay ordinary income taxes. I have found with many of the people that I've worked with throughout my life that this is where the majority of their money is invested. Now that is starting to change as these other types of accounts become more popular. But for people that are already retired or entering retirement, a large portion of their money is invested in these tax deferred types of accounts. And then the second bucket is what's called tax free accounts. So this is going to be your Roth IRAs, Roth 401ks, your HSA accounts. Now with these, you do not get any tax deduction up front except for the HSA, which makes it one of the best types of accounts in the world. And I did a complete video on why HSAs are so awesome. But for a Roth IRA and a Roth 401k, no tax deduction up front, but the money then grows tax deferred. And then as long as you follow the rules, when you take it out in retirement, that money is going to be completely tax free to you. So now there are contribution limits on these types of accounts, the same way there are with traditional IRAs and traditional 401ks. But this is the second type of tax bucket that you can invest your money in. And this is growing in popularity tremendously considering everybody thinks that tax rates are going to be higher in the future. So why not pay the taxes now and have that tax free money later on. And then the third bucket is taxable accounts or after tax accounts. And now this is going to be like a regular brokerage account that you could hold in your name or joint with your significant other, bank accounts, CDs, money market accounts. This is for money that you invest after you've paid taxes on it. So you get paid, money hits your bank account, and then you decide, you know what, I got this extra money that I want to invest. I'm going to buy some stocks or whatever inside of a brokerage account, or I'm going to buy a CD or bonds or whatever it might be. Those are in taxable accounts. And for these, there's no contribution limit. You could invest a million dollars this year in a brokerage account if you are able to do so, which would be great. But these are going to be taxed a little bit differently than those tax deferred, those retirement accounts or those tax free accounts. So now with brokerage accounts and taxable accounts, if you hold the assets in there longer than a year, then you get favorable capital gains tax rates against those. So we'll talk about that a little bit as well, but that is the third bucket. And what's nice about brokerage accounts and taxable accounts is that you have maximum flexibility. So you don't have to wait till age 59 and a half. There are no restrictions. You can take that money and use it in your 30s, in your 40s, or whenever life throws a curveball at you and you need to get some money, you know, you could go ahead and sell whatever securities you have or investments you have and use that money whenever you want to. Now, once you have money in all three of these buckets, then you could determine the most tax efficient way to take withdrawals to be able to spend some of that money. Even if we talk about before age 59 and a half, like let's say, for example, you're 40 years old and you're miserable at your job and you want to leave and you want to do something. Maybe you want to travel for a year. You just want to take a year off, or maybe you want to start your own business and you know that you're really not going to have any income. If you have a taxable brokerage account that you've been investing in, even if you have a lot of gains in there, one thing that you could do is you could sell a security, you could sell a portfolio, stocks, bonds, whatever it is, and you could pay 0% capital gains tax on those as long as your income is below the levels. For 2022, if you're married filing jointly, you could have up to $83,350 of income, including capital gains, and owe 0% taxes on the capital gains. People use this strategy even if they just have an off year with their income and they sell some appreciated stock where they have some capital gains to keep them below that limit and pay 0% on it. It's just an option. When you have these taxable brokerage accounts, it's a way to make sure that you're optimizing the tax system to look at these tax brackets and take advantage if you're able to sell some stuff and be in that 0% capital gains tax bracket. Another strategy could be, like I mentioned before, is to take out the amount that you've invested into your Roth IRA. Now, again, it's not great to take money out of your Roth IRA because that's going to grow tax-free forever, but it is available to you if you do have an off year or you need some to supplement your income in some way. You do have that flexibility where you could take that out. Another opportunity in down years with your income is that you could do Roth conversions. If you're in a low tax bracket, if you're not making a lot of money in a certain year or you take a year off, you could convert money from your traditional IRAs over to your Roth IRAs. You would pay tax on it in the year that you make the conversion, but you would be in the lower tax bracket. By doing it then and getting the money into your Roth where it will then grow tax-free forever, that could make a ton of sense also. You have these opportunities because you have these different buckets that you could control and pull from to make these strategic decisions. Now, where things get really interesting is once you actually get into retirement and you have money in these three different buckets, then you could get very strategic as to how you're going to pull your income in retirement. A very typical setup for people that are retired now is they have a pension, they have Social Security, and then they have this big IRA or 401k and they pull an income from that every year. Now, in this instance, there's very little flexibility. Any money that comes out of the IRA is going to be taxed, your Social Security is going to be taxed depending on what your actual income is, up to 85% of your Social Security will be taxed, and then your pension is going to be taxed, and that's just the way that it is. So, all of your income that's coming in is basically subject to taxes. But now as Roth accounts become more popular, the trend is moving towards going into retirement with having more tax-free money, also having the taxable brokerage account, and then having your 401ks and tax-deferred money as well. And how you could use this to your advantage in retirement is what you could do. Social Security, hopefully we're all going to have Social Security, so that'll be a portion of our income. Pensions, very few of us are going to have pensions in retirement. Those are pretty much going by the wayside. So, we're going to be relying on our investments to pull an income from. So, what you could do is you could pull a certain amount of money from your traditional, your tax-deferred accounts from your 401k or your traditional IRA, and you could pull enough so that you hit the top of a specific tax bracket. So, for example, in 2022, you could withdraw enough from your pre-tax accounts to keep you in that 12% tax bracket. So, in 2022, it's $83,550 of income. Once you go over that, then you go into the 22% tax bracket. So, the strategy would be withdraw enough from your tax-deferred accounts to reach the top of that 12% tax bracket. And then after that, supplement your income from your Roth accounts, from your tax-free accounts. This way, you are only keeping yourself in a 12% tax bracket on your IRA withdrawals. And then that Roth money, it just comes out tax-free. And then you could also, on top of that, in the brokerage account, depending on how your investments are doing inside of there, you could withdraw some money from there tax-free. The way you could do that is maybe you offset some of the capital gains with some of the losses that you had throughout the year. So, we call this tax-loss harvesting. It gives you the opportunity to do that as well. So, you sell some of your losers to offset the gains from your winners. And then you're able to pull some money out of there without any tax consequences. But even if you do have gains in there, it'll be at the favorable capital gains tax rates. So, by doing this, by having these different levers to pull, you could see where you fall each year as far as the tax brackets go and pull from these different buckets. This is going to be the most efficient way for you to pull income in retirement and stay in those lower tax brackets, even though you might have a pretty big income. Now, if all you have are tax-deferred accounts, then you have no options. You're going to have your pension, your Social Security, and whatever money you need to live on, you're going to be pulling it from that IRA. And it's all going to be taxed at ordinary tax rates. And you're probably going to be in a 22% or a 24% tax bracket. And by the time we get to retirement, who the hell knows what it's going to look like. There might not be 12% or 22%. It might be 22% and then 32% and 34%. The rates, they're probably going to be higher. Taxes are probably going to be higher when we get to retirement. So, having the flexibility to fill up the low tax bracket and then go Roth after that, it is a great way to go. And then having the taxable brokerage account to be able to mess with that a little bit and do a little tax loss harvesting and peel some money out of that every year as well. It really is a smart strategy to be able to withdraw tax efficiently in retirement. And the only way that you can put yourself in this position is by starting now. So, one thing that you should do right now is you should list out all of your investments and see what bucket do they fall into. And are you tax diversified? And if you're not, now is a great time to get started with that. And it's also worth noting that you can split your contributions. So, you don't have to go all one way or all the other. So, in your 401k plan, you could do half of it into the Roth option and you could do the other half into the traditional option. And then the employer match is also going to go into that traditional option. And also, don't forget about that taxable brokerage account as well. Try to put aside some savings each year and grow that taxable brokerage account so you have flexibility with that at certain points in your life just in case you need to. Not only will it benefit you before retirement, but as I just mentioned, it could benefit you after retirement as well and give the opportunity to do some tax loss harvesting and get some gains out of there without paying any taxes on them. All right. That is it for this one. I hope that you found this one helpful. Please make sure to hit that subscribe button if you've not done so already. Hit the like button if you enjoyed this video. Check out SchoolOfPersonalFinance.com. I'll see you in the next video. Thanks.