Diversifying Tax Strategies (It Works for Investment Strategies, Why Not for Taxes?)

Diversifying Tax Strategies (It Works for Investment Strategies, Why Not for Taxes?)

Should I keep my retirement in my traditional IRA or 401(k) or convert to a Roth?

This vexing question, like most complicated questions, “depends.” Some of the key questions the “answer” depends on include:

  • Will your tax rate be lower in retirement than it is now? (the lower your retirement tax rate, the more likely a Roth conversion will be beneficial)
  • Will have you unusually low income tax rates this year or next because of a temporary loss of compensation (due to bad business, layoff or other circumstance)? (temporary lower income tax rates now make the “cost” of paying income taxes on Roth conversions much more palatable)
  • What rate of return on your investments do you expect on your retirement assets? (the higher the return, the more likely you will recoup the cost of converting traditional IRA to a Roth)
  • How many years until I retire? (younger workers are more likely to benefit from a Roth than will individuals closer to retirement age)

Since many investors will conclude, sensibly, they ‘don’t know,’ one interesting strategy we found was from Investment News: “diversify.”


Just as investors diversify their asset risk amongst bonds, stocks, real estate and commodities, or even their particular risk in a particular asset class like stocks by owning stocks internationally and abroad, small and large, and amongst different sectors (eg, healthcare, technology, utilities, financials, industrials, etc.) and companies.  In other words, convert some traditional IRA money to Roth so that some of your savings withdrawals will be taxable (from a traditional IRA) and some not taxable (from a Roth IRA).  Much like the investment strategy of not putting all your eggs in the basket of one or too few asset ‘baskets,’ the author suggests individuals hedge their “tax risk” in the event that, for instance, tax laws change, tax rates go up across the board for all income levels, or investment returns underperform.

Some excerpts:

“Advisers, plan sponsors and investment gurus preach diversification as a critical factor in investor success. To maximize the return on your portfolio, the argument goes, it’s crucial to maintain a proper asset allocation aligned with one’s risk tolerance.

“But in emphasizing diversification only in terms of asset classes and sectors, advisers may be downplaying another important aspect of a well-diversified investment portfolio: tax diversification through pretax 401(k) and Roth 401(k) contributions.

“Choosing the right, tax-smart combination of sources for retirement assets is an important factor in long-term investing success. In addition to current age and future earnings potential, factors such as current versus future tax rates, company matches and assets outside of a retirement plan need to be considered when determining whether to contribute income pretax into a 401(k), or pay taxes upfront in a Roth 401(k). “

You can read the rest of the article at Investment News.



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