Introduction: Diversification Is More Than Asset Allocation

When we hear “diversification,” we often think about spreading investments across stocks, bonds, and other asset classes to manage risk. While this approach is essential, there’s more to creating a truly resilient financial plan. Diversification must also account for how taxes affect your investments and how income sources are managed over time.

In this post, we’ll dive deeper into two important dimensions of diversification: tax and income. Understanding and applying these strategies can help you gain more control over your financial future, reduce risks, and build a more stable foundation for retirement.

Part 1: Tax Diversification

What Is Tax Diversification?

Tax diversification involves holding investments in different types of accounts that are taxed in various ways—taxable, tax-deferred, and tax-exempt accounts. By diversifying your investments across these accounts, you have more flexibility to manage taxes efficiently throughout your life, particularly in retirement when managing your tax liability becomes even more crucial.

Why Tax Diversification Is Crucial for Your Financial Plan

1. Controlling Your Tax Bracket in Retirement: As you transition into retirement, your income will likely come from multiple sources: Social Security, pensions, investment withdrawals, and perhaps part-time work. The goal of tax diversification is to give you control over how and when you withdraw from each of your accounts. By carefully choosing which account to withdraw from in a given year, you can avoid being pushed into a higher tax bracket.For example, if you’re in a lower tax bracket in a particular year, you might prioritize withdrawals from tax-deferred accounts (401(k), traditional IRA), which are subject to income tax. In years when your tax rate is higher, you can instead tap into tax-exempt accounts like a Roth IRA, where withdrawals are tax-free.
   
   
2. Managing Required Minimum Distributions (RMDs): One challenge of tax-deferred accounts is that at age 73 (under current laws), you’re required to start taking RMDs. These distributions are taxed as ordinary income, and for some retirees, large RMDs can push them into higher tax brackets, resulting in larger tax bills. By maintaining a balance of tax-deferred and tax-exempt accounts, you can reduce the impact of RMDs. For instance, if your RMDs are large enough to significantly increase your taxable income, you can offset the impact by taking additional withdrawals from a Roth account, where there’s no tax liability.
   
   
3. Adapting to Changes in Tax Policy: Tax laws are always evolving, and it’s difficult to predict future tax rates. This is why it’s important to have a mix of accounts with different tax treatments. For example, if tax rates increase in the future, you might rely more on tax-exempt accounts like a Roth IRA. Alternatively, in a low-tax environment, you might prioritize withdrawals from tax-deferred accounts.
   
   
4. Taking Advantage of Tax-Loss Harvesting: Taxable accounts offer unique opportunities for tax-loss harvesting, where you can sell investments that have lost value to offset gains elsewhere in your portfolio. This strategy reduces your capital gains tax liability and provides a way to manage taxes during market downturns.

How to Build Tax Diversification Into Your Portfolio

Building a tax-diversified portfolio is about more than just maximizing contributions to a 401(k) or IRA. It involves understanding the tax treatment of each account and planning for the long term. Here are key steps to take:

• Contribute to a Mix of Account Types: During your working years, contribute to both tax-deferred and tax-exempt accounts. This might mean balancing contributions between a 401(k) and a Roth IRA to maximize future flexibility.
  
  
• Plan Withdrawals Strategically: In retirement, plan your withdrawals to minimize tax liability. Withdraw from tax-deferred accounts when your taxable income is low, and use Roth accounts or taxable accounts during higher-tax years.
  
  
• Use Tax-Loss Harvesting: In taxable accounts, take advantage of market volatility by selling underperforming assets to offset capital gains, reducing your tax bill.

Part 2: Income Diversification

What Is Income Diversification?

Income diversification means building multiple streams of income, especially in retirement. Relying on just one or two sources of income, such as Social Security or a pension, can leave you vulnerable if something changes—such as a reduction in benefits or poor market performance.

Why Income Diversification Is Important for Retirement Planning

1. Reducing Dependence on Any Single Income Source: Relying heavily on one income stream—whether it’s Social Security or withdrawals from your retirement accounts—can be risky. If market performance is poor or Social Security benefits are reduced in the future, you could face financial shortfalls. By having multiple sources of income, such as a combination of Social Security, pensions, investment income, and part-time work, you mitigate the risk of losing any single source of income.
   
   
2. Smoothing Out Income in Retirement: Retirement income isn’t always predictable. For example, market downturns might reduce the amount you can comfortably withdraw from your investments, or unexpected expenses could strain your budget. Diversifying income sources provides more flexibility to adjust as needed. If investment income is down, Social Security or a pension can help cover living expenses, and vice versa.
   
   
3. Maximizing Social Security Benefits: Social Security remains a key part of most retirees’ income, but how and when you claim those benefits can impact your overall retirement income. By waiting to claim Social Security until your full retirement age or later, you can increase your monthly benefit. Meanwhile, relying on other income sources, such as a pension or withdrawals from investment accounts, can help cover your expenses during those waiting years.

Strategies for Diversifying Your Income

1. Social Security and Pension Plans
   While Social Security provides a foundation of income for many retirees, it’s unlikely to cover all your expenses. If you have a pension, you can combine it with Social Security to create a more secure base of income. However, not everyone has access to pensions today, making it crucial to supplement your retirement with other income streams.
   
   
2. Investment Withdrawals
   Income from your investment portfolio—stocks, bonds, mutual funds—will likely be a significant part of your retirement plan. By diversifying your portfolio with a mix of income-generating assets, like bonds, you can create a steady stream of income.
   
   
3. Part-Time Work or Consulting
   Many retirees find that part-time work or consulting can be a valuable source of income. Whether it’s working a few hours a week or taking on freelance projects, having income from work can reduce the need to draw down your investments too quickly.
   
   
4. Annuities
   Some retirees choose to invest in annuities, which provide a guaranteed income stream in exchange for a lump sum of money upfront. While annuities aren’t for everyone, they can offer peace of mind for those who want a predictable income.

Conclusion: A Holistic Approach to Diversification

Diversification is about much more than just investment choices—it’s about preparing for the future by building a strategy that includes tax diversification and income diversification. By diversifying your tax strategies and income sources, you can reduce risks, manage taxes more effectively, and create a more stable financial foundation for the long term.

If you’d like to explore how to implement these strategies in your financial plan, schedule a consultation with Suttle Crossland Wealth Advisors today. Let’s work together to build a strategy that’s tailored to your life and your goals.