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Tax diversification and the twenty-bagger by 2020



March 18, 2011 – Comments (6)

I've posted before in this space about the unusual concept of 'tax diversification'.  You never really hear a lot about this, but you should if you use any kind of tax-advantaged retirement account.

You see, as soon as you get into a situation where your money grows income-tax-deferred, such as a 401(k) or a traditional IRA; or a situation where future withdrawals will be made tax-free, such as any vehicle with the word "Roth" in its name; you are involving yourself in a prediction about your future marginal tax rate as relates to your current tax rate.  If you have the option to contribute to either type of vehicle and you do not do so, preferring instead to make your investments in a taxable account where the first $3K of capital losses offer a tax deduction, you are also making a prediction about your future taxes.

Diversification is an idea about asset allocation; you allocate your assets among different categories of investment in order to mitigate your exposure to unexpected changes in any one category.  As it happens, I think your (and my) future marginal tax rate is one of the least predictable effects that can be found, and it is certainly one of the larger effects in terms of the effect size, as it generally rises linearly as a percentage of your portfolio size at cash-out time.  Imagine trying to predict what state you will be living in during your retirement - and trying to know what the state income tax rate there will be?  Will we have a Federal V.A.T.?  No one knows.

I think it's a good idea to have taxable, tax-deferred (IRA) and tax-free (Roth) accounts cooking at any given time, and in general I believe that future tax rates, ceteris paribus, will be higher, not lower.  As you enter a certain income level it becomes more and more difficult to get any assets at all into a Roth situation; I have spent the last 10 years maxing out my Roth contributions and rollovers, and I believe I am of necessity finished with that now.

So just today, I started phase 3.  For my assumptions, I have believed the following:

- Roth should include stocks with high dividend yields, to eliminate noisome double-taxation; and high-growth riskier plays.

- Traditional tax-deferred should include items like S+P index funds, bond funds, things expected to closely track their markets - why should Uncle Sam reap all the benefits of my riskier bets? 

- The taxable account is for a third category, which I call the Peter Lynch style of growth investing, and the Fool calls Hidden Gems - small companies with great prospects, where you buy 5 names, expect 1 to go out of business, three to underwhelm, and one to pull a twenty-bagger.  The twenty-bagger, of course, is the one that matters.  In this style of investing, if your position size is not too large you do want to be able to harvest your $3K of expected tax losses every year.

Which brings me to my next question, Fools: what small-cap name is going to pull a twenty-bagger by 2020?  Give me your best ticker.  

6 Comments – Post Your Own

#1) On March 18, 2011 at 1:18 PM, lquadland10 (< 20) wrote:


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#2) On March 18, 2011 at 1:27 PM, Jbay76 (< 20) wrote:

I am shooting with Copper Fox Metals (CPFXF).  They have found a considerable copper mine, with other goodies invovled, that they believe will produce copper, among the other goodies, for 20-25 years.  They hevn't begun extracting yet, but the CEO of Freeport McMorran commented on the lack of availability of new copper mines in the world, especially ones thaty FCX owns.  Thus CPFXF will play a critical role in this area.  I suspect that once CPFXF starts extracting the metals, their company will draw a lot of attention.  maybe its a take-over, or just a booming increase in shareholder value.  Don't know, but it'll take its shareholders to the moon, Alice!  And I am buckeled up for the ride.


I am currently focusing more on my Roth than my taxable account.  Every chance I get I roll over an old companies 401K into my Roth.  I toooriginally thougt of using the Roth for dividend-style investing.  But given the current situation, miners and PM stocks offer the most explosive growth, so I have changed to take advantage of that.  In the end, you really need a lot of shares, and therefore invested capital, in order to truly take advantage of dividends.  My new apporach for my Roth is to build up $$ via investign in miners etc, and then once I build up that $$, and I no longer have time to focus on stocks due to family requirements etc, then I'll switch to closed end funds like ETY, EXG etc. I will still invest in miners andthe like in my taxable account.

But, in the end, I feel that tax brackets will be higher for everyone in the future and so I think it worthwhile to focus on the Roth instead of the tax-deferred investment.  The taxable will be used for major purchases, home downpayment if we're inclined to get a home, or to relocate to another country, etc.while the Roth is stricty retirement.


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#3) On March 18, 2011 at 2:15 PM, chk999 (99.96) wrote:

This is an excellent blog. Future tax rates almost have to go up, so tax diversification is a great idea. I expect at some point the politicians are going to try to tax Roth withdrawls, so we have to be prepared to oppose this.

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#4) On March 18, 2011 at 3:13 PM, tdonb (41.09) wrote:


You can make withdrawls from a roth for purchasing your first home-tax free. I am thinking of opening one for my daughter for this idea.

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#5) On March 18, 2011 at 3:43 PM, Jbay76 (< 20) wrote:

@Chk999, yeah I almost am positive, 100%, that the politicians will do something like this becuase we're broke now and unless drastic change occurs, we'll contineu to go down that red path.  Roth's will become very appetizing becuase the rich don't have Roth's. Roth's are a vehicle for people who make less than 100K for single filer, or 150 for joint filers.  So, again, the middle class may get screwed.  But, since I believe anything can happen, there is still the chance that they leave roth's alone.



I was aware of that caveat, but I will not use it for any purpose beyond retirement  UNLESS politicians  try to tax it.  Then I will try and yank it all out.  I recall you can do such a thing as long as the roth and/or the money put in the Roth is 5 years or older.  I currently don't see the monkeys going after it so I have been fine with my speculation, but if you can veify it one way or the other that'd be appreciate.

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#6) On March 18, 2011 at 10:30 PM, ikkyu2 (98.18) wrote:

You can make withdrawals from a traditional up to $10K tax free for a new home.  I ended up not doing that.

You can withdraw your contributions from your Roth account at any time, tax and penalty free, and do whatever you like with them.  Most people don't realize this. You cannot, however, withdraw monies that are accounted for by appreciation of those contributions.  That means that if you ever take a Roth withdrawal you are going to need to know your past basis of contributions and you are going to have to track that basis, minus any withdrawals from it, going forward.  A lot of work. 

You also can't get your contributions back into the Roth if you change your mind, short of recharacterizing and refiling, which is only permitted in some circumstances.  In general I don't recommend it.

One of the nicest things to leave your descendents is an Inherited Roth IRA.  You never have to take an MRD out of it before you die, and it passes on its tax-free status to your heirs.

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