I have written many times about the value of keeping one’s investment portfolio well-diversified across numerous investment asset classes. But diversifying your portfolio with respect to income taxes can also be a valuable way of maximizing the wealth you get to keep and pass on to your heirs. Here’s a high-level explanation of how it works.

Most taxpayers have access to three types of investable savings accounts: those that are taxable annually, those that are tax-deferred until retirement, and those that are tax-free over one’s lifetime (and even beyond). The first group includes brokerage accounts, bank accounts, mutual fund accounts held directly at fund companies, and bank CDs, to name a few. The second is comprised of IRAs, 401(k)s, 403(b)s, and most other retirement accounts, as well as many kinds of annuities. The tax-free group includes Roth retirement accounts such as Roth IRAs and Roth 401(k)s.

Different types of investments also allow for varying degrees of tax advantages and disadvantages. Gains in individual stocks, for example, are not taxed until the shares are sold, and at a capital gains tax rate which historically has been lower than ordinary income tax rates for higher-income earners. Bonds generate taxable income regularly whenever interest is paid and therefore are less tax efficient (except for certain types such as municipals). Taxes on a portion of distributions from real estate investment trusts (REITs) are delayed until the shares are subsequently sold. Precious metals investments such as gold and silver are taxed at a higher capital gains rate than stocks and real estate when sold. And mutual funds comprising these various types of securities can add an additional layer of taxation complexity.

Compounding the challenge for tax minimization is the fact that no one has any clue as to what income tax rates will be in the future. eFile.com estimates that the tax code has been amended or revised over 4,000 times just over the last ten years. Since the passage of the Tax Cuts and Jobs Act in 2018, federal income tax rates are among the lowest they’ve been in decades. While that suggests that rates are more likely to increase rather than decrease in the future, future potential political and economic events reduce any predictions made today to little more than pure guesses.

What’s the best way to tax-diversify your portfolio? During your working years begin at the account level by attempting to maintain some amount of your savings across all three types. In your taxable accounts you should try to maintain at least enough to cover taxes every year (which are most efficiently paid from these types of accounts rather than directly out of your retirement accounts). The perfect balance between tax-deferred and tax-free retirement accounts is impossible to achieve because of future rate uncertainty. How much to put into the one versus the other largely depends on your current tax situation. A good approach is to put together a multi-year plan where tax-free savings are increased during lower income years and vice-versa, subject of course to the various limit rules. Building up your tax-free accounts (i.e. via Roth conversions) can be especially effective during the years between retirement and age 72 before required minimum distributions start.

Next focus on the investments in the accounts. Plan to locate (purchase) the more tax-efficient investments (such as stocks or stock funds) in the less tax-efficient accounts (such as brokerage accounts) and the less tax efficient assets (such as bonds) in accounts that are more tax-beneficial. But If you try to maximize tax efficiency by putting only stocks in your taxable accounts, rather than a mix of stocks & bonds, you will end up incurring the higher taxes associated with stock sales rather than bond sales whenever it’s time to do asset class rebalancing. Recognize also that post-retirement you will likely have to change your tax allocation strategy since you will be withdrawing more from your portfolio than adding to it.

Optimizing tax diversification over time is one more technique you can add to your investment strategy to increase your lifetime savings. Remember though that asset class diversification is always more important than tax diversification. Put another way, “Never let the tax tail wag the investment dog.”