Maximize your tax benefits with a mix
of retirement products

"Should I invest in a 401(k) and a Roth IRA?" You may have heard that the best plan is to max out your contributions to a 401(k). But, by investing in accounts with different types of tax treatments — tax-free, tax-deferred and taxable — you can benefit from a diversified portfolio and have access to your funds when you need them.

Create a tax-smart mix

Just as diversifying your investments can help lower your risks and broaden your opportunities, tax diversification can do the same. It's about providing yourself with the opportunities to invest with the greatest tax efficiency throughout your life — especially when facing uncertainties about future tax rates and your own financial situation.

Here's an overview of the three types of tax treatments, the products that feature them and some tax-smart ways to use them:

1. Tax-free income: Roth IRAs and Roth 401(k)s allow you to make tax-free withdrawals if certain conditions are met. Picture yourself on the threshold of a higher income tax bracket in retirement. By making a timely withdrawal from a tax-free Roth account, you may save on taxes by avoiding that higher tax bracket.
2. Tax-deferred income: Traditional 401(k)s and traditional IRAs (depending on your income) provide you with an up-front tax deduction and tax-deferred growth, but you will have to pay ordinary income tax on withdrawals. Depending on your tax bracket in retirement relative to when you worked, you'll benefit more by either saving on taxes during your working years or after you retire. But how do you know? Will your income rise or fall? Will tax rates rise or fall?Because of many uncertainties, having some of your investments exposed to either type of tax treatment could be helpful.
3. Taxable income: Compared with the tax benefits offered by tax-deferred or tax-free accounts, taxable accounts may not seem to offer much. But they can be a key part of a well-rounded mix. Let's say you face a large one-time expense, such as a vacation, a child's wedding, or a major home repair. By withdrawing money from the taxable account, you'll pay just the long-term capital gains tax, currently at a very attractive rate. Your tax-deferred and tax-free accounts will keep growing undisturbed and you won't be assessed any penalties. The liquidity of a taxable account can be very important.

Optimize asset location

To get the most out of tax diversification, also make sure that you place the right investment in each type of account so that you can gain the most. For example, bonds produce ordinary income, which is taxed at a higher rate than capital gains. By placing bonds in a tax-deferred account and stocks (which produce capital gains) in a taxable account, you'll get the greatest tax benefit.

Obtain cash from your life insurance, but be careful

Certain life insurance policies, such as variable universal life, can build cash value through tax-deferred growth and allow you to withdraw money tax-free. However, if you take money from a life insurance policy, you'll have to make sure you maintain a high enough cash balance. Otherwise, you could cause the policy to lapse. Use caution and talk to your financial advisor and tax professional.

Consider a Roth conversion

As you build your retirement plan, you may seek to shift its tax balance. High-income earners have a tremendous opportunity to do so next year. Until now, only those who earn less than $100,000 a year have been able to convert from a traditional IRA to a Roth IRA. But beginning in 2010, Roth IRA conversions will be open to all investors. To do a Roth conversion, you have to pay taxes up front, but for 2010 Roth conversions only, you'll have an option to spread taxes to 2011 and 2012. Either way, you'll benefit from tax-free withdrawals in retirement.

Expand your estate planning opportunities

Roth IRAs also offer much greater flexibility because there are no required minimum distributions (RMDs). That opens up some powerful estate planning opportunities. For example, you could transfer assets to your heirs income tax-free. Then, your non spouse beneficiaries take distributions from the inherited Roth IRA based on their own life expectancy.

Note that Roth 401(k)s are subject to RMDs, unlike Roth IRAs. But by rolling over a Roth 401(k) to a Roth IRA, you can tap into all of the Roth IRA benefits.

Tax diversification is a complex area and it can be challenging to know what your best strategies are. To make the most of your long-term opportunities, work with your financial advisor and tax professional.

Investment products are not insured by the FDIC, are not deposits or obligations of or guaranteed by a financial institution, involve investment risks including possible loss of principal, and may fluctuate in value.