A New Diversification: Tax Diversification

Taxes, taxes, taxes: those three words have thus far defined the campaign trail, as hundreds of members of government are up for re-election this year.  However, taxes aren't just important to your government, nor your paycheck, but to your retirement plan as well.

Diversifying Your Tax Risk

Tax diversification has nothing to do with anything illegal or actions in a “gray area.”  In fact, tax diversification is becoming one of the most important elements of financial planning.  Today's tax laws are nothing like yesterday's, and tomorrow's are sure to be different than today, which is why it’s critically important to diversify your risk.  You want to be ready for changes in the tax code and have a flexible plan to work around Uncle Sam.

Minimizing Your Risk

With ideas like the Fair Tax, Flat Tax and all types of other different taxing schemes being thrown around in Washington, it’s impossible to know whether today's tax code will be anything like the tax code when you're ready to retire.

Post-tax accounts like ROTH IRAs could be taxed again if the Fair Tax passes, or it could generate higher tax bills if taxes decrease before your retirement date.  Likewise, pre-tax accounts like 401ks could generate higher than expected tax bills if taxes rise before your retirement date.

A proper balance will help you minimize your own risk, while still opening yourself to the possibility of paying lower taxes on your retirement savings.

How to Balance Your Assets

The best way to balance your risk is to open both a pre-tax retirement account and a post-tax retirement account and invest equally in each.  By doing so, you have a net zero exposure to changes in the tax code and can plan to save without the fear of higher taxes in the future.

The best strategy is to open a 401k through your place of employment, or a regular brokerage account (both pre-tax) combined with a Roth IRA (post-tax).  Though it is possible tax laws will not change before you reach your retirement date, the best planning is always completed by eliminating as many variables as possible.  And with tax rates as high as 35%, it's a good variable to remove.