Everybody has heard the saying, “don’t put all your eggs in one basket.” Most don’t question the wisdom of diversification and even those who do will generally admit that hedging your bets makes sense if you aren’t a full-time investor. Why, then, does nobody ever talk about tax diversification? Since most people do most of their retirement investing through a pre-tax 401k plan at work, balancing that by contributing to a Roth IRA makes a certain amount of sense (you still have time to contribute before the Roth IRA deadline). If you make too much income to contribute to a Roth IRA (poor you!), a 401k rollover to Roth IRA is always an option.
What Is Tax Diversification?
Tax diversification is a pretty simple concept. It involves investing your assets in a variety of different types of accounts with different tax treatments in an effort to hedge future unpredictable changes in tax rates. Will taxes be higher or lower 30 years from now? The conventional wisdom is that they will be higher for a variety of very logical reasons, but honestly, congress has a habit of doing things that don’t make sense.
401k plans, Roth IRAs, and plain old taxable accounts all have different tax characteristics. With a 401k you get a tax break now but have to pay income tax at your full marginal income tax rate on withdrawals in retirement. Roth IRAs, on the other hand, have no current tax benefits; however, your withdrawals after age 59 1/2 are 100% tax-free forever. Taxable accounts, meanwhile, are eligible for neither a current tax write-off nor do they escape taxation on withdrawal. But on the plus side, gains on shares held more than a year are taxed at the long-term capital gains rate, which are currently lower than regular income tax rates (but again, who knows how long that will last?).
Since nobody knows what future tax rates will be, it makes sense to hold investments in a variety of different accounts with a variety of different tax characteristics. Investors who lean too heavily on their 401k may be in for a rude awakening come retirement. Better to hold at least some of your portfolio in a Roth, just in case.
