Thursday, May 5, 2011

A DIFFERENT KIND OF DIVERSIFICATION?


Pathways Advisory Group, Inc.
Jeff Karst, Associate Planner












With investment portfolios, we always discuss diversification (a key component to reducing risk). Diversification comes from investing in US, foreign, and emerging markets. Within those areas we invest in large, small, value, and market (growth) stocks. By diversifying among these areas, we can build (what we believe are) excellent portfolios. There is another aspect of diversification that we have begun to discuss: tax diversification.
When investing, we have the option to use three basic types of “tax” accounts. First, is a taxable account (Personal, Community Property, or Trust account). Here, you pay taxes in the year that you realize a gain or receive a dividend. Currently, long-term capital gains and qualified dividends are taxed at a maximum 15% rate. Ordinary dividends and short-term capital gains are taxed at your ordinary rate (maximum of 35%). You pay taxes each year even if you don’t withdraw money from the account. This is the “Pay As You Go” method.
The second type of account is a tax-deferred account such as a Traditional deductible IRA or 401(k). These accounts provide a tax deduction now for the amount that is deposited. If you contribute $10,000 to your 401(k), then your taxable income is reduced by $10,000. The money then grows on a tax-deferred basis. You will pay ordinary income tax on the amount withdrawn. This is the “Save Taxes Now, But Pay Later” approach.
My favorite option is a tax-free Roth IRA. The money contributed to a Roth is already taxed. You don’t pay any tax on earnings as it grows within the Roth IRA and qualified withdrawals are tax-free. The downside of these accounts is not everyone is eligible to contribute and there is a maximum amount that can be contributed each year. This is the “Already Paid And Pay Nothing Later” method.
Choosing among these “tax” options is not always easy. There are several questions to ask yourself. Would I rather be taxed now or in the future? What will my tax bracket be when I retire? Will Congress change the tax bracket levels in the future? What are the consequences if the 15% rate (for long-term capital gains and qualified dividends) goes away? Sometimes the best answer is to diversify among all three. No one knows what taxes will look like in the future. Any prediction would be purely speculative. Tax diversification is a way to mitigate the risk of an unknown tax future.

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