Where we are now, financially…

So I moved all may accounts over to Fidelity. What do I have? An IRA and Roth IRA for both my wife and I, which were the transferred accounts, plus my wife’s 401(k), are at Fidelity. I have my own 401(k) through my work at yet another company. I was initially interested in Vanguard, with its extensive line of index funds. However, I had less in the Roth IRA accounts than the account minimum, which is currently $3000. (Vanguard also charges a $10 fee on accounts of less than $5000, which also includes my IRA account, plus a $10 fee on each index fund in each account.) So, for the moment, Vanguard is out, although I might consider moving the accounts over once I have more than in each account. In any event, as my wife and I are contributing into our 401(k)s, I will roll over the IRAs into the Roth IRA accounts in 2010, when the income limits on this type of transaction go away. People talk about diversifying your accounts, and when they say this, they usually mean diversifying among different asset classes (Stocks, bonds, real estate, etc.) Having both the 401(k) and Roth accounts would also diversify based on tax rates.

What does this mean? Distributions from the 401(k) grow tax free but are taxed at your income tax rate when you withdraw. For the Roth accounts, the income tax is paid now, the account grows tax free, and withdrawals are tax free. So you would obviously contribute more to the account on which you would pay the lower income tax rate.

However, (and this is where the diversification part comes in) you cannot be sure what your tax rate will be in the future when you retire, so you cannot be sure if you are paying a lower tax rate now or (in my case) 30 years in the future. You also can’t be sure if the government will change the tax rates in the future, and if they do, what the rates will be. So, the point of tax diversification is to hedge your bets, and you put part into an account taxed now, and part into an account taxed later. Just like with asset diversification, some assets will do better than others. With tax diversification, one way will work better than the other, but you don’t put all your eggs in one tax basket and picking the wrong choice.