Most investors are aware of the importance of diversification. However, some investors take diversification one step further. In addition to investing in different asset classes (e.g., stocks, bonds, cash, commodities, real estate), these investors choose to hold investments in different types of accounts to obtain the benefits of tax diversification.
The basic premise: Spreading money among accounts that are treated differently for tax purposes provides investors with the flexibility to better manage their taxes and potentially enhance their after-tax returns.
Tax-deferred Accounts
Traditional registered retirement saving accounts (RRSP) and other employer-sponsored retirement plans allow investors to defer income taxes on investment earnings. And pretax or tax-deductible contributions to these accounts provide current tax savings. When investors eventually withdraw their money, however, they must pay taxes on the previously tax-deferred amounts they receive — at the ordinary income-tax rates in effect in the year of withdrawal.
Tax Free Saving Accounts (TFSA)
Investors can also make investment through Tax Free Saving Accounts. Tax free is better than tax deferred, but it also has a downside: It cannot accept pretax or tax-deductible contributions. So investors receive no immediate tax benefit.
Taxable Accounts
Investing in taxable accounts generally means paying taxes on any earnings each year. An upside: Under current law, the tax rates on net long-term capital gains are lower than the rates that apply to ordinary income. Investors may be able to manage their tax exposure by:
- Holding appreciated stock instead of selling it. This strategy defers taxes on the gains. Of course, by holding their stocks, investors risk price declines.
- Investing in mutual funds that attempt to keep investors’ taxes to a minimum by controlling portfolio turnover and timing the realization of gains and losses.
Using tax-deferred, TFSA, and taxable accounts strategically can help investors navigate what might be a changing tax landscape in the years ahead. Don’t deal with tax issues on your own. Call us right now to find out how we can provide you with the answers you need.
