Tax Diversification and How it Can Save You in Retirement

Have you ever heard of tax diversification?

How about "Don't put all your eggs in one basket."? You've undoubtedly heard that phrase a million times. But as cliché as this is, it still holds very true.

In the world of investing, we tend to use this phrase to suggest that putting all your money into a single investment or type of investment is a bad idea; and it usually is. However, when we are discussing whether to invest in a Roth vehicle (be it 401k or IRA) vs. investing in a traditional, pretax investment, we are referring to tax diversification.

What is tax diversification?

Well, the same way we diversify our assets between stocks, bonds, and cash investments in an attempt to hedge our bets against market loss, we should also diversify our assets amongst vehicles that tax us differently to hedge our bet against our future tax liability.

The same way we diversify our assets between stocks, bonds, and cash investments in an attempt to hedge our bets against market loss, we should also diversify our assets amongst vehicles that tax us differently to hedge our bet against our future tax liability.

Consider this: When 401k plans were first introduced, they touted an important benefit; tax-deferred contributions. This was (and still is) a fantastic feature. You defer paying taxes on all your contributions and earnings until you withdraw the money in the future.

Initially, people were almost always told that they would likely be in a lower tax bracket in retirement (presumably because they would have less income), and therefore would get to make withdrawals from their 401k at a tax rate lower than what they would have paid when they were working.

20 years ago, that may have been generally true. As time progresses, though, we are seeing that retirees are less and less likely to be in a lower tax bracket when they retire than retirees of the generations before them. This may be caused by many reasons, not the least of which is Uncle Sam’s tendency to tinker with the tax rates over time.

This is where a Roth 401k (or IRA) might come in handy. In a Roth vehicle, you get no immediate tax break on your contributions. However, when you withdraw the money in retirement (assuming you are 59 ½ and have held the account 5 years) you can withdraw all contributions and earnings tax-free. So if you end up in the same or higher tax bracket in retirement, you come out ahead of the tax game!

Conversely, if you do end up in a lower tax bracket, you essentially paid more in taxes than you would have if you had invested your money in a pretax 401k.

Bottom line: If your taxes are lower in retirement than they are while you are working, you are better off making pretax contributions. If you will be in the same or a higher bracket, you are better off in a Roth vehicle.

The reality is that there is just no way to be certain where you will be when the time comes to retire. Too many uncertainties will impact your position, the most significant of which is out of your control (the IRS and what tax rates they enact in the future). So what to do??

Diversify your assets amongst vehicles of different taxation methods. Put some of your money in a Roth 401k and some in a regular 401k. This is beneficial for one main reason: when retirement comes, you choose what sources to draw your money from, effectively choosing how much you pay in taxes. If money you withdraw during the year has the possibility of pushing you into a higher bracket, you might opt to withdraw Roth assets to balance out any taxable income you have. Conversely, if your income for the year has sagged, you might consider taking withdrawals from a pretax 401k source since you may have some wiggle room before you reach a higher tax threshold.

Tax risk is major opponent of retirees. By diversifying you give yourself an investment edge over your retiree predecessors.

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