How to Manage Tax Diversification Like a Boss


It pays to make sure you have access to tax-free money, tax-deferred money and some taxable money, especially during the withdrawal phase of retirement.

Imagine yourself on the day before you become financially independent. As you cross the line, you begin to look at your various accounts and the tax status of each. Have you made sure that those accounts include money that is not subject to the same uniform tax effects? Tax diversification means having access to some tax-free money, some tax-deferred money and some taxable money. This allows you to protect against changes in the tax brackets and gives you a certain amount of control over the amount of tax you pay in retirement. Consider the following two lawyers, both financially independent and both looking to spend $100,000 this year. To keep things simple, both portfolios are assumed to be the same size after taking into consideration taxes.

Lawyer A has a portfolio that is entirely tax-deferred, consisting of a rollover IRA created after he moved his 401(k) into a traditional IRA.

Lawyer B has a portfolio consisting of a mix of accounts. He started a Roth IRA in law school, made some backdoor Roth IRA contributions during his career, contributed to his 401(k), an HSA and also put some money into a taxable account.

If both want to spend $100K, how would they do it?

Lawyer A pulls $100K out of his rollover IRA. There’s no penalties if he’s over 59 1/2 and there’s no required minimum distribution if he’s not yet 70. The money is tax-deferred, so he will have to pay income taxes on the amount withdrawn. His adjusted gross income is $100K. He takes the married standard deduction of $12,600 and personal exemptions of $8,100 to arrive at $79,300 of taxable income of which he’s going to pay approximately $11,368 of taxes at an effective rate of 11.4%.

Lawyer B has options to achieve his $100K income. Maybe he withdraws $10K from his HSA to cover healthcare expenses, all tax-free. He could use appreciated stock in his taxable account for any charitable contributions, again all tax-free. Assuming no charitable giving, he’d still need $90K in my example. He could pull $50K from his Roth IRA which would not be taxed. He’d need another $40K from his Traditional IRA to bridge the gap, which would generate $40K in taxable income. Because he had a taxable investment account, he may have been able to do a little tax-loss harvesting throughout the years and thus have a $3K loss he can deduct from his income, knocking it down to $37K. After taking the standard deduction and personal exemption, his taxable income drops to $16,300 for a tax bill of $1,630.

The first lawyer pays an effective tax rate of 11.4% but the second lawyer only pays an effective rate of 4.4%. That’s the magic of tax diversification at work.

TAX DIVERSIFICATION LESSONS

1. Options are Valuable. The first lesson is quite clear. It pays to have options when you retire since you can aggregate money from different accounts to cover your expenses and trigger lower taxes as a result. Most interesting is how the second lawyer only paid tax in the lowest income bracket at 10%.

2. You Need to Max Your Retirement Accounts. Even the lawyer with 100% tax-deferred portfolio only paid an effective tax rate of 11.4%. For a lawyer in NYC, every dollar you contribute to a 401(k) may save you taxes in the circa 40% range. Saving taxes at a 40% tax rate and paying them at an 11.4% rate is a winning proposition every time.

3. Maximizing Your Roth IRA as a Law Student. Getting started with a Roth IRA as a law student is a great way to get the Roth IRA contributions going, particularly during a period of your life when you likely have low income and so are not paying much taxes on the income anyway. After you start working, you’ll be able to do backdoor Roth IRA contributions to boost the account. At only $5,500 a year, this account may never be a huge portion of your portfolio but even if it’s 10-20% you’ll be able to use the tax-free withdrawals to top up your income and save from being forced to withdraw tax-deferred money at higher income tax brackets.

4. Use Low-Income Years to Do Roth IRA Conversions. If you retire early, take a year off, become a stay-at-home parent or otherwise have a lower income one year, take advantage of the lower income by doing Roth IRA conversions. You can convert tax-deferred Traditional IRA money to tax-free Roth IRA money by paying income taxes on the conversion. If you have no income one year, you could convert the tax-deferred money by paying taxes at the low 0, 10 or 15% tax brackets. Additionally, this will reduce the required minimum distributions you have to take after age 70 (a requirement of Traditional IRAs). Finally, consider doing the Roth IRA conversions while a resident of a state with no income taxes. A lawyer working in NYC may save around 40% for every dollar contributed to a 401(k). During a transition period in Florida, that same lawyer could do Roth IRA contributions, pay 10-15% federal tax and no state income taxes. That same lawyer could later retire to California and spend the money from his Roth IRA both federal and state tax free.

5. Tax Benefits of Taxable Accounts. Taxable Accounts have a lot of tax benefits, although they should be funded after maxing out all retirement accounts, including backdoor Roth IRAs and HSAs. In a taxable account, you pay the lower capital gains tax rates on any gains in the account. You also get a step-up to your cost basis at death, have the ability to tax-loss harvest and can donate appreciated stock to charity without triggering any taxes.

Let’s talk about it. Are you deploying these tax diversification strategies? Do you have money saved across several different types of accounts or have you been focusing only on one account? Let us know in the comments.

Joshua Holt

Joshua Holt A practicing private equity M&A lawyer and the creator of Biglaw Investor, Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest financial advisors that provide financial advice for a fair price.

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    Thirteen thoughts on How to Manage Tax Diversification Like a Boss


    1. I’m bookmarking this post! This is one area where I’m starting to dig a little more. After years of just being a TurboTax guy, I got a CPA to help us with taxes, but more importantly, for developing some strategies to help us in the long haul.

      Right now, we max out my 401(k) and contribute my wife’s up to the match. Then we both push some into the Roth accounts and my HSA. I will probably make the HSA contributions a bigger priority just because of how tax-advantaged that can really be.

      — Jim

      1. Also, you may consider looking into futures contracts. Gains on futures contracts, regardless of how long you hold the contract, get taxed at a 60/40 split; 60% of the gains taxed at the long term rate and 40% at the short term rate.

        Futures contracts are a different animal than investing in equities, but over the long run, they may be worth looking into if you want to devote the time to learn them and how to invest in them.

      2. Jim – I wish more people thought about it in terms of “developing tax strategies”. I think you nailed it. Too often people focus on trying to figure out how to save on taxes around tax filing time. It really is all about developing tax strategies and that takes time to figure out and implement. I may write a whole post about it. Thanks for the idea.

        Sounds like your contributions are diversified. I’d max out your HSA ahead of your Roth IRA and even at the expense of maxing out your 401K. The triple-tax advantage benefits of the HSA are too great to pass up in the event you have medical expenses in the future. If you end up not needing the HSA money for medical expenses, at age 65 it’s effectively treated like a Traditional IRA and you will only pay income taxes on the gains. Yes, this is 5.5 years later than when you can withdraw money penalty-free from your 401(k), but you can simply stack the accounts and withdraw from your 401(k) first and then your HSA later once you hit 65. Again, this only presumes that you won’t use the money for a qualified medical expense or won’t be able to withdraw it to cover medical expenses incurred previous to turning 65 but where for whatever reason you didn’t use HSA money.

        I wrote a whole article on HSAs here:

        https://www.biglawinvestor.com/stealth-ira-health-savings-account-hsa/

        -Josh

    2. I really wish I had thrown my summer associate money into a Roth IRA. Unfortunately, I didn’t know anything about personal finance back then, so what did I do? I spent it all!

      Since I’ve gotten myself back on track. I’ve tried to follow this advice as well and get tax diversification in my retirement assets. Opened up an HSA this year and maxed that out. Maxed our Roth the last two years. And then I have money in a 401k from my old firm and now in my state pension plan and 457b plan.

        1. @Michael – Interesting about the taxation of futures contracts. Sounds like it allows you to make a short term investment (or “speculative bet”) and get preferential 60% LTCG treatment. What type of futures contracts are you opening?

    3. “Saving taxes at a 40% tax rate and paying them at an 11.4% rate is a winning proposition every time.” What an excellent point! I have co-workers who don’t contribute much to the deferred compensation plan or only contribute a minimal amount. I work in government so many seem to rely mostly on the pension. Often times they’ll talk about how ideas to increase yield by investing in individual stocks, alternative investments, etc, etc. They never think to save on taxes which is a big win when you live in a high tax state.

    4. I think most people ignore tax diversification because 1) it’s somewhat difficult to estimate how much tax you’ll pay in a hypothetical situation in the future and 2) there is so much uncertainty around the tax law changing in the near future.
      However, it’s essential to have some sort of plan quantified and have the flexibility to adjust it later if you need. This is a great explanation of how to go about making that plan!

    5. Hey Josh! Thank you for the tax strategy insight! I am wondering–what would your advice be to those who can split their contribution in traditional 401k and roth 401k accounts? Would splitting half and half be a good tax strategy? Can you foresee potential downfalls or complications?

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