How do I plan when tax rules keep changing?

By Walter Updegrave, senior editor


(MONEY Magazine) -- How can you plan your financial future when the government continually changes the rules, especially regarding taxes? -- Wayne Moffatte, Middleburg Heights, Ohio

You can't completely insulate yourself from changes in government policy. But you can reduce the chance such shifts will derail your well-laid plans. How? By doing what savvy investors and business people have done for centuries: Hedge your risks by diversifying.

Take income taxes. You can't control rates. Heck, sometimes you can't even tell what the rate will be next month let alone in the distant future, as the recent wrangling in Washington over the extension of the Bush-era tax cuts proved.

But you can control your exposure to rate hikes somewhat by spreading your retirement savings around accounts that receive different tax treatment. Regular 401(k)s and IRAs, for instance, mostly hold pretax dollars, which are taxed at ordinary income rates at withdrawal.

Should all your savings sit in such accounts, a hike in income tax rates would reduce the amount of aftertax spending cash available to you in retirement.

If some future Congress boosts rates so the $50,000 a year you're withdrawing from your traditional IRA is taxed at, say, 28% instead of 25%, you'd be clipped an extra $1,500 a year by the IRS.

But if you also have money stashed in a Roth 401(k) or IRA, those funds would escape the higher income tax rates, since qualified withdrawals from Roths are tax-free.

Another benefit: Unlike withdrawals from traditional 401(k)s and IRAs, qualified Roth withdrawals don't count in figuring how much, if any, of your Social Security benefits are taxable.

You can further diversify in taxable accounts by investing in stock index funds that rack up much of their return in the form of unrealized long-term gains. Such gains aren't taxed until you sell, when they're subject to more favorable long-term capital gains rates.

Of course, taxes are hardly the only way government actions might affect your finances. For example, critics of QE2 -- the Federal Reserve's second round of "quantitative easing" that involves the Fed buying some $600 billion in Treasury securities to nudge down longterm interest rates -- warn that it also has the potential to boost inflation and send the dollar lower. But diversifying can help here too.

All else being equal, U.S. investors who own securities denominated in foreign currencies experience a boost in returns when the greenback heads south.

So by investing, say, 15% to 25% of your stock portfolio in foreign stock funds, you ensure that your portfolio's performance doesn't depend solely on the fortunes of the U.S. economy (the health of which hinges in part on government actions) and also profit a bit from a falling buck.

As for inflation, maybe the Fed will be able to deftly manage monetary policy so that we avoid a surge in prices. But just in case, you might devote, say, 10% or so of your savings to investments that provide inflation protection, such as real estate or TIPS (Treasury Inflation-Protected Securities) funds.

For high-quality funds in these and other categories, see our MONEY 70 list of recommended funds ("The Best Funds, Made Easier," page 90). But perhaps the most effective way to cushion yourself against uncertainty, no matter what the source: Save more.

The larger your nest egg, the more wiggle room you'll have to deal with everything from tax hikes to market setbacks. Bottom line: You can't stop the rules from changing. But you can improve the odds that your plans will still pan out no matter what curves are thrown your way. To top of page

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