Just about everyone is familiar with the concept of diversification when it comes to building a retirement portfolio. As a fundamental principle of investing, diversification can help to lower overall risk and increases your chances of achieving long-term financial goals. Yet many investors give little thought to adding another layer of diversification using a variety of tax-advantaged accounts.

How tax diversification works

Dig deeper into your portfolio—beyond asset classes and subclasses—and examine the way each investment is taxed. Chances are, you have some taxable and tax-deferred accounts, like those shown below. Including a tax-free component, like a Roth IRA, can provide more flexibility during your retirement years by helping to maximize growth potential and minimize taxation.

The Roth IRA difference

• Like a Traditional IRA, any income earned can compound on a tax-deferred basis over time.
• Roth IRA is unique because withdrawals are tax-free when you retire, if you hold the account for at least five years and are age 59½ or older.

Roth IRA conversions and tax rates

One way to diversify the tax efficiency of your investments is to convert a tax-deferred account, like a Traditional IRA, to a Roth IRA. You have to pay ordinary income taxes on the amount converted in that tax year, plus the conversion will boost your reportable income. This is where tax rates come into play. If you believe that your future tax rate will be higher, converting and paying income taxes now, while you’re in a lower tax bracket, may help lessen your tax burden later when you draw income. Roth IRA conversions can help level the playing field if tax rates do increase in the future.

Special tax election in 2010

For 2010 conversions only, you can spread your tax liability over the following two consecutive years—divided equally in 2011 and 2012. This one-time provision may offer incentive to those who wish to convert without the full impact of conversion taxes. You may still elect to pay taxes on the entire conversion in 2010.

Hedging taxes through diversification

It can be challenging to estimate your future tax rate, especially if your retirement is a long way off. And, your income is not the only factor—no one can truly predict legislative changes in tax rates. That’s why diversifying the types of tax-advantaged investments in your portfolio may be a more practical approach.

What’s the right mix?

There is no pre-determined allocation of taxable, tax-deferred and tax-free accounts for a retirement portfolio. Talk to your advisors about these tax diversification strategies:

• Keep an emergency fund in a liquid, taxable account
• Invest in your employer’s 401(k) or other tax-deferred plan, if available
• Maximize any employer match
• Diversify asset classes and tax efficiency
• If you have multiple Traditional IRAs, consider converting one or more to a Roth IRA
• If eligible, contribute to a Roth IRA

Scope it out with your advisors

Like asset allocation, tax diversification requires a comprehensive portfolio review between you and your financial and tax advisors. Given the number of variables involved in the decision to convert to a Roth IRA, it’s critical for you to talk with trusted professionals.

¹ Excluding nondeductible contributions.

² Assuming withdrawals meet requirements for tax-free treatment.

To learn more about strategies for retirement, including commentary from Thomas Rowley, IRA calculators, and additional information on traditional and Roth IRAs, please visit our retirement section.

Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. It was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and changes frequently. You should always consult your own legal or tax advisor for information concerning your individual situation.

IRA owners are encouraged to seek the advice of an attorney or tax advisor that specializes in this area.

The opinions in this piece are not necessarily those of Invesco. Information in this report does not pertain to any Invesco product and is not a solicitation for any product.