Roth IRAs and Taxes: Diversifying Your Portfolio for Taxes

by kristine on October 19, 2011

As a financial planner I’m always telling clients they need to diversify.  If you didn’t understand the danger of having all of your eggs in one basket before, the volatility we’ve experienced in the market these past few years should have you convinced by now.  Well taxes are a lot like investments when it comes to the need to diversify.  Tax laws change just like the stock market does, so depending on one tax strategy is similar to investing in just one stock.

Why you need to diversify for taxes

Probably the biggest reason you need to diversify your investments for tax purposes is the fact that tax laws are constantly changing.  As a result, what is a good tax planning strategy now may not be in a year or ten years or twenty years from now.

Tax planning is important to minimize the taxes you pay, but you have to update your tax plan for changing tax laws.  Today’s tax plan could cost you hundreds or thousands of dollars if you don’t update it and the tax laws change.

In addition to changes in the law, your financial situation could change.  If you develop a tax plan assuming that you will be in a lower tax bracket when you retire, but you find yourself in a higher tax bracket instead (due to a generous pension, an inheritance, or due to working longer), your current tax strategy could backfire.

Finally, having a diversified tax portfolio can provide planning opportunities that you might not have otherwise.  For example, having both tax-deferred and tax-free accounts when you retire allows you to pick and choose which accounts you will take withdrawals from.

Roth IRA and TaxesHow to diversify for taxes

In the past, people have invested the majority of their money in tax-deferred company retirement plans, or if they didn’t have a company plan, a traditonal IRA.  While these are great investment vehicles and have their own advantages, it’s important to invest in different types of investments with different tax treatments.

In addition to your company retirement plan, you should also consider investing in a Roth IRA.  A great strategy is to invest just enough to get the company matching (if you are lucky enough to work for a company that still offers matching contributions), then invest the rest of your money into a Roth IRA.  If you still have money left to invest, you can either go back to your company retirement plan or you can invest in a taxable account.

If your income is too high to contribute to a Roth IRA, you can contribute to a non-deductible IRA and then convert to a Roth IRA.  This strategy is fairly new as the income limit for Roth IRA conversions was just $100,000 until Congress eliminated the income limit starting in 2010.

And of course, you can always invest in taxable investments outside of the traditional and Roth IRAs discussed above.  With capital gain rates still at historical lows, investing in taxable investments has been good a tax strategy for many people, as the capital gain rates are lower than the rate most people would pay on a traditional IRA or 401K withdrawal.

Tax Planning Strategies When You Have a Diversified Tax Portfolio

Many people aren’t aware that they can take their Roth IRA contributions out at any time for any reason, without paying any taxes or penalties.  This little unknown rule means you can use Roth IRAs for a wide variety of financial goals, not just saving for retirement.  Since you always have access to your contributions you can use your Roth IRA as an emergency fund, to save for education costs (for yourself or your children) or to purchase your first home.

The most popular feature of the Roth IRA is that qualified distributions are tax-free.  If you have a variety of investments when you retire, such as 401Ks, traditional IRAs, Roth IRAs and taxable investments, then you have the ability to choose which account you will take money out of when you need it.  This flexibility gives you tax planning opportunities that you wouldn’t have if you had only invested in your company’s tax deferred 401K.

Example:  Let’s assume that you are retired and you need approximately $15,000 in addition to your pension and Social Security income to cover your living expenses each year.  If you only had a 401K, then 100% of the money you took out of that 401K would be subject to tax.  However, if you have a 401K, and a Roth IRA, you can choose how much to take out of the 401K and how much to take out of the Roth.  This is very beneficial if you are in the 15% tax bracket and you can only have another $5,000 before you reach the next tax bracket (currently 25%).  With a diversified tax portfolio, you can choose to take $5,000 from your 401K and the remaining $10,000 from your Roth IRA, which would save you roughly $2,500 in income taxes (the $10,000 you would have had to take from your 401K times the 25% tax rate that would apply if you jumped into the next tax bracket).

Hopefully you can see the value of diversifying your money for tax purposes in addition to investment purposes.  As always, please consult with a qualified tax professional to determine the best tax planning strategy for you.

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