NEW YORK (MONEY Magazine) -
You may think your retirement stash is thoroughly diversified because it's spread across large and small stocks, growth and value shares, government and corporate bonds.
I hate to shatter your illusions, but have you even considered whether you're tax diversified?
Making sure that the after-tax value of your savings isn't riding on just one tax rate doesn't get a lot of attention. But make no mistake: Failure to diversify your tax exposure before you retire could reduce what you have to live on later.
Which is why we need to have a frank talk now about ways to gain more control over your tax bill in the future.
401(k) pros and cons
The beauty of a 401(k) is that contributions are excluded from taxable income, giving you an immediate break, plus your gains compound without the drag of taxes. But you're not escaping taxes, just postponing them until you withdraw the money -- at which point, of course, you assume you'll be in a lower tax bracket.
But what if you find yourself facing a higher tax rate in retirement? Your home mortgage deduction could shrink or even disappear, and you won't have 401(k) contributions pushing down your taxable income.
If through diligent saving and savvy investing you have racked up huge balances in your 401(k) and other tax-deferred accounts such as traditional IRAs, you'll face large mandatory withdrawals. That income, combined with fewer or smaller deductions, could nudge you from, say, the 15 percent bracket to the 25 percent, or from 28 percent to 33 percent.
Indeed, when you consider that your withdrawals must be large enough to cover your expenses plus the taxes on the withdrawals, finding yourself in a higher bracket isn't as unlikely as you might think. Especially when you consider that up to 85 percent of your Social Security benefits can become taxable if your income, over and above those benefits, exceeds certain thresholds.
And Congress could hike tax rates -- not an outlandish prospect given the size of our budget deficits and the looming bill for Social Security and Medicare benefits.
Which brings us to the downside of having retirement assets heavily concentrated in a 401(k) or similar tax-deferred account: Instead of working the tax system to your advantage by deferring taxes at a high rate and paying them at a lower one, you could end up doing just the opposite.
Or you could live your retirement years in a state of anxiety, knowing that if tax rates go up, you'll have to boost withdrawals to maintain your standard of living, which would increase the risk that your savings will run out.
Roth to the rescue?
There is a way to avoid this downside: Invest in a Roth if you're eligible (couples with an adjusted gross income of less than $160,000, singles under $110,000) or, if they come to pass, plans like the Bush administration's proposed Lifetime Savings Accounts and Retirement Savings Accounts.
With a Roth, you pay the tax on your contribution today for the promise of tax-free withdrawals in retirement. So you are better off if you end up in a higher tax bracket. Of course, if you fall into a lower tax bracket in retirement, you will have paid taxes at a higher rate than if you'd opted for a tax-deferred account.
If you knew for sure which tax rate you'd face in retirement, you'd know whether a tax-deferred vehicle like a 401(k) or a tax-free account like the Roth would be a better deal. But with our insanely complicated tax code, where your effective rate depends on the interplay of deductions, exemptions, credits and phaseouts, that's a hard call.
So how should you cope with this uncertainty? Diversify. Fund accounts that generate both tax-deferred and tax-free income -- and have some assets in your taxable accounts that create most of their return through unrealized capital gains or a rising share price.
Unrealized gains aren't taxed until you sell, and as long as you hold these investments longer than a year, you're taxed at the long-term capital-gains rate, which now maxes out at 15 percent vs. 35 percent for ordinary income and short-term capital gains.
Keeping money in these three pots -- tax-deferred, tax-free and long-term capital gains -- will give you some maneuvering room when it comes to retirement.
If it appears that your income needs will be more modest in a given year or you have deductions to lower your taxable income, you can rely on withdrawals from your 401(k) or IRA. If withdrawals from your tax-deferred accounts are likely to push you into a higher tax bracket, you can tap your Roth for tax-free income.
Having access to a Roth's tax-free withdrawals carries what I believe is an important psychological advantage as well -- the peace of mind of knowing that your account balance represents spendable cash, not a theoretical figure from which taxes must be paid. If in retrospect you find you paid a few extra bucks in taxes for the privilege of lower expenses and less anxiety in retirement, I'd say that's money well spent.
Finally, having a taxable pot of long-term capital gains gives you the potential in a given year to create essentially tax-free income by offsetting realized gains with capital losses in your taxable account; you might even be able to deduct up to $3,000 of losses against your income. Hey, every bit helps.
There's no guarantee, of course, that this three-pot strategy will get you the biggest retirement savings payout. But barring any really harebrained future tax laws, diversifying your tax burden along these lines should give you more leeway to minimize the government's share of your nest egg.
Senior editor Walter Updegrave is the author of "Investing for the Financially Challenged" (Warner Books). You can reach him at email@example.com.