Diversification is the first rule of investing. You knew that, right? But have you thought about tax diversification? Yep. Smart investing isn't just what you own, it's where you own it and how it gets taxed when you take it out. From a tax standpoint, you have three different types of accounts:

• Regular (taxable) accounts, like your checking and savings accounts and accounts with mutual funds or brokerages that are not in any type of retirement account. You pay tax year-by-year on any interest you earn or any gain (profit) when you sell an investment.
• Tax-deferred retirement accounts, such as traditional IRAs and 401(k). The money went into the account tax-free, so you'll owe tax on the money when it comes out.
• Tax-free (Roth) accounts: you already paid tax on the money that went into the account, and any growth will be tax-free when you take it out, assuming you follow the rules. (See Rules for Taking Distributions from Tax-Deferred Retirement Savings Plans, p. 3)

These two examples will point out why you might want to build some tax diversification into your savings and investments.

Large expenses = large tax bills

John and Sarah retired last year. This year, they're remodeling the house and taking a really nice trip to celebrate their retirement. They expect to spend $45,000, and they're going to use money in their traditional 401(k) and IRA to pay for it. That will push them into the 25% federal and 5% state tax brackets. They'll have to take out $64,286 in order to pay the taxes and have $45,000 left. That's a tax bill of $19,285. In addition, that added income could cause some of their Social Security benefits to be taxable as well.

If John and Sarah had taken the $45,000 from a Roth account, there would be no income tax. And if they had sold investments in a regular, taxable accounts, they might not have owed anything either. If they owned the investment longer than 12 months and if they are in the 15% tax bracket, their capital gains rate (see table 16-1) would be 0%; they would owe no tax on the sale.

What will your future tax bracket be?

Trish has worked all her life. Her federal tax bracket varied from year to year. Sometimes she was in the 15% bracket, other years she was in the 25% tax bracket. There were a couple of years when she paid no income tax. She took advantage of those "low tax" years and put all her retirement savings into a Roth IRA and the Roth option in her job's 403(b) plan. Putting the money into traditional, tax-deferred accounts wouldn't have saved her much if anything in those years.

It's the year 2030 now. Trish is 65 and retired. Tax rates have gone up tremendously. If she takes all the money for all her living expenses from her tax-deferred accounts, she will be in the 40% tax bracket this year! She decides to take just enough from those accounts to "fill up" the lower tax brackets, and she'll take the rest of the money she needs from a Roth account. There may also be a future benefit to her approach: by using some of the money from the tax-deferred accounts now, her required minimum distributions starting at age 70 ½ will be smaller. That may help her avoid the highest tax brackets in those years when she has no choice about how much to take from the accounts.

Managing uncertainty

No one knows for sure what tax rates will be in the future, or how other rules will change. So it's impossible to choose an optimal strategy for managing income taxes over our lifetimes. That's why diversification makes sense – it's a way of managing risk, or uncertainty. If you have some money in each of the different "tax buckets," you'll have more flexibility than you would if all your money was in one type of account.

How are you handling future tax uncertainty? Share your thoughts with our other readers by posting your comment below.