By Thomas Rowley, Director of Retirement Business Strategy
Just about everyone is familiar with the concept of diversification when it comes to building a retirement portfolio. As a fundamental principle of investing, diversification can help mitigate volatility and potentially increase your chances of achieving long-term financial goals. Yet many investors give little thought to adding another layer of diversification by using a variety of tax-advantaged accounts.
How tax diversification works
Dig deeper into your portfolio — beyond asset classes and subclasses — and examine the way each investment is taxed. Chances are you have some taxable and tax-deferred accounts, like those shown below. Including a tax-free component, such as a Roth IRA, can provide more flexibility during your retirement years by helping to maximize growth potential1 and minimize taxation.
||Savings and brokerage accounts, mutual funds
||Annually on earnings
||Traditional IRA, 401(k), 403(b)
||On earnings and contributions2 when withdrawn; if made prior to age 59½, may be subject to an additional 10% federal income tax penalty
||Roth IRA or Roth options within a 401(k) or 403(b)
||None on contributions and earnings when withdrawn3
Roth IRA conversions and tax rates
One way to manage the tax liability of your retirement assets is to convert a tax-deferred account, like a traditional IRA, to a Roth IRA. You have to pay ordinary income taxes on the amount converted in that tax year, plus the conversion will boost your reportable income. This is where tax rates come into play. If you believe that your future tax rate will be higher, converting and paying income taxes now, while you're in a lower tax bracket, may help lessen your tax burden later when you draw income. Roth IRA conversions can help level the playing field if tax rates do increase in the future.
Hedging taxes through diversification
It can be challenging to estimate your future tax rate, especially if your retirement is a long way off. And, your income is not the only factor — no one can predict legislative changes in tax rates. That's why diversifying the types of tax-advantaged investments in your portfolio may be a more practical approach.
|What's the right mix?
There is no predetermined allocation of taxable, tax-deferred and tax-free accounts for a retirement portfolio. Talk to your financial and tax advisors about thses tax diversification strategies:
- Keep an emergency fund in a liquid, taxable account.
- Invest in your employer's 401(k) or other tax-deferred plan, if available.
- Maximize your employer match.
- Diversify asset classes for tax effiency.
- If you have multiple traditional IRAs, consider converting one or more to a Roth IRA.
- If eligible, contribute to a Roth IRA.
The Roth IRA difference
Like a Traditional IRA, any income earned can compound on a tax-deferred basis over time. A Roth IRA is unique because withdrawals are tax free when you retire, if you hold the account for at least five years and are age 59½ or older.
Talk with your advisors
Like asset allocation, tax diversification requires a comprehensive portfolio review with your financial and tax advisors. Given the number of variables involved in the decision to convert to a Roth IRA, it's critical for you to talk with trusted professionals.