Before we talk about tax diversification, lets talk about diversification in general. Diversification in investing is a good thing. If you invest your money too narrowly, you take on too much risk. For example if you invest in a single company and that company goes out of business, you will lose all of your money. Even investing in single sectors is too narrow, as sectors go in and out of favor. So you want to invest your money across a variety on sectors and companies.
Another type of diversification is time diversification. The market as a whole tends to rise and fall. If you invest your money all at once you risk investing at a high point. But if you invest in increments over time, you will invest some at the high points, but also some at the low points. If you are investing equal dollar amounts, you will buy more shares at lower prices, and fewer shares at higher prices. This is called dollar cost averaging.
Now let’s look at tax diversification. What is it? Tax diversification is the idea that when investing money in tax-deferred accounts, you invest some in pre-tax accounts, and some in post-tax accounts. The creation of the Roth IRA helped make this possible.
Previously, there were pre-tax types such as 401k and traditional IRA. You were able to invest your money before the taxes were taken out. Your money would compound tax-free until you took the money out. Then you would have to pay taxes on the money as ordinary income.
But with the Roth IRA, and the new Roth 401k, you invest the money after the taxes have been taken out. You will have less to invest. But now that money goes on to compound tax-free. Then when you reach the age of 59 1/2, you can start taking the money out without having to pay a dine in taxes!
So is why is tax diversification good? Because tax rates fluctuate. You don’t know if the tax rates will be better know, or when you retire. So why gamble? Invest money in both pre-tax and post-tax types of retirement accounts.