Diversify Your Tax Profile

Taxes change, just like investments do, and in order to be prepared for whatever comes through the chambers of Congress, you have to diversify your tax profile. Simplistically, this just means that you need to have good mix of investments that are both tax-deferred and tax-free. For example, a Roth IRA is a tax-free investment vehicle. You put in dollars that are already taxed and your earnings and principal are tax-free when you withdraw them. A Traditional IRA is a tax-deferred investment vehicle. You put in dollars pre-tax and your earnings and principal grow tax free but they are taxed when you withdraw them. What happens if we do away with income tax and instead raise sales tax (a value added tax) across the board?

See, now your Roth IRA comes out of your fund tax free but is then “taxed” when you start buying things. You are essentially double taxed – once on the contribution side and then once when you spend it after withdrawing it. Now let’s say that the income tax is re-evaluated and it is doubled to help pay for nationalized health care… now you’re basically screwed on your tax deferred investments because you’re paying more taxes (and you win on your tax-free investments).

So, the next time you go to plot out your retirement portfolios, remember to not only diversify your investments but also remember to diversify your tax profile!