| 08 October 2008
Diversification is the best way to protect a portfolio against investment risk but there is another important concept called tax diversification. Although nothing is as certain as death and taxes, there is nothing quite as uncertain as future tax policy. For those of us who don’t have a crystal ball to see into the future, it makes sense to hedge our bets by holding assets with different tax status.
Assets are treated differently for tax purposes. Regular investments like mutual funds create taxable income when dividends, interest or capital gains are realized – even if distributions are reinvested. Under current tax law, though, dividends and capital gains receive special tax rates which are lower than ordinary income rates such as on wages.
Contributions to retirement accounts like traditional IRAs avoid current taxation and the earnings grow tax-deferred to the future. However, when distributions are eventually taken the entire amount will be taxed at your regular tax rate at the time – not at the preferred rates for dividends and capital gains.
Roth IRAs are funded with after-tax money, but the government has promised that the earnings will forever escape taxation to the account owner. To confuse things even more, there are other accounts that are partly taxable and partly tax-free to the investor, such as non-deductible IRAs and non-qualified annuities.
Investment performance should be viewed based on the after-tax rate of return since that is the amount that ends up in your pocket. With the various investments taxed in different ways, though, how do you know which is best, and what type of return to expect? After all, the following questions make it difficult to be confident in any one course of action.
* What will tax brackets look like in the future?
* Will dividends and capital gains be taxed at preferred rates, and if so, will they be higher or lower than they are now?
* Will the government fulfill its promise regarding the tax treatment of Roth IRAs?
* What will happen if there is a radical change in tax policy down the road, such as a flat-tax or consumption tax?
* What tax bracket will you be in during retirement compared to now?
Risk is just another name for uncertainty, and these questions suggest uncertainty of future taxes. To reduce this risk, one solution is to diversify by using different types of investment accounts. For instance, many people have a retirement account at work and some regular mutual funds. Adding a Roth IRA would provide a third type of investment from a tax perspective. Similarly, many companies are starting to offer a Roth 401(k) option in addition to the traditional 401(k).
Converting some money from a traditional IRA to a Roth IRA might also make sense for some taxpayers.
In addition to hedging your bets regarding tax policy, having money in different tax buckets provides an opportunity to “manage” your taxable income during retirement. For example, withdrawing strategically from more than one type of account for income might prevent you from unnecessarily creeping into a higher tax bracket.
Just as we can’t predict or control investment performance, we have no influence over future tax policy. However, we can take advantage of special opportunities presented to us and employ tax diversification to reduce uncertainty by using investment vehicles that are taxed in different ways.
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