In investing, the concept of diversification is to decrease your overall portfolio risk by holding a variety of investments within multiple segments of the market. But equally important is considering a tax diversification plan.
Regardless of what taxes are today, we are never able to predict with full certainty what taxes will be in the future. Thus, it is important to diversify within different tax categories.
It is important to diversify your funds among taxable, tax-deferred, and tax-free categories:
TAXABLE ACCOUNTS are those with no current or future tax benefits, such as checking, savings, or other nonqualified investment accounts. Any money made on these types of accounts is fully taxable in the year the gain is realized.
TAX-DEFERRED ACCOUNTS are those with a current (but not future) tax break, for example, Traditional IRAs and 401(k)s. In these accounts, contributions are made with pretax dollars and the money grows tax-deferred. However, tax is due at time of withdrawal at ordinary income rates.
TAX-FREE ACCOUNTS are ones such as Roth IRAs or Roth 401(k)s. In these accounts, contributions are made after tax with no tax due when withdrawn.