This guest post is by KMC @ Advanced Personal Finance (while I am still on vacation). More information about KMC and his blog is available towards the end of this post.
When investors talk about diversification, they’re typically referring to diversification of investments for the purpose of reducing risks. But there’s another kind of diversification. It’s called tax diversification and you might be practicing it without knowing it.
Tax diversification is the idea that you should have investments subject to each of the various tax treatments. The idea applies not only to U.S. citizens, but also to those of other countries as well. There are three types of tax treatments for our purposes: tax-deferred, tax-free, and taxable.
The three account types
* Tax-deferred. Tax-deferred accounts are those that grow tax free until they are liquidated, at which time full taxes are due. Examples are the 401(k) and traditional (”deductible”) IRA. You invest pre-tax dollars. The full amount of money goes to work for you, compounding until withdrawn. At the time of liquidation, the entire amount withdrawn is taxed as ordinary income.
* Tax-free. Tax-free accounts use after-tax money to buy investments which then grow without ever being taxed again. Examples are the Roth 401(k) and Roth IRA and municipal bonds. In these types of account, you purchase the investment with your after-tax income. The investment then grows over time. When liquidated, the total account balance is tax-free.
* Taxable. These accounts invest after-tax income. When the investment is liquidated, the earnings are taxed again. An example is a regular brokerage account.
How tax diversification works
In short, you use tax diversification when you split your investable dollars between the three types of accounts. Tax rates and treatments are moving targets. By using tax diversification, you’re hedging. (Click here to read more about hedging)
Why use it?
You simply cannot know what the tax brackets will look like at retirement (unless you’re within a year of retirement, I suppose). Using this technique, you’re spreading the risk of using any one type of account (and also increasing potential returns).
For example, if the bulk of your retirement investments are in a combination of traditional IRA and 401(k), at retirement all of that money is fully taxable. As of today, it’s taxed as ordinary income. If your tax bracket is lower in retirement, you made a shrewd move. If it is instead higher, you lost money by using only the tax-deferred accounts. So whether you think Roths are bad or good, it makes sense to have at least a portion of your retirement savings there.
I personally use this technique in my investments. Currently, I have 8% pre-tax going to my traditional 401(k) and 11% going to a Roth 401(k). We also have a taxable account we fund each month.
About the author: KMC is a thirty-something family man with a wife, three year old daughter and one on the way. After graduating college with $5,000 in credit card debt and $9,000 in student loans, his new wife finally got him to shape up and get fiscally responsible. He went a little overboard and developed a serious interest in personal finance. He currently writes about the topic at advancedpersonalfinance.com. Check out his post titled “The Reported Rate of Inflation is a Lie“. (Feed link to Advanced Personal Finance)