Investors must deal with uncertainty every day. Without knowing what the markets will bring, they try to get good returns without bearing excessive risk.
The classic solution is diversification — holding a broad array of global stocks and bonds. By spreading your risk, you obtain some protection against a disaster in any single holding. Even through the chaos in the markets brought about by President Trump’s on-again-off-again tariffs, well-diversified portfolios have been shielded from the wildest swings in the markets.
This survival strategy makes sense in thinking about your taxes, too.
Every taxpayer must deal with at least two kinds of uncertainty. First, you don’t know exactly what your income will be in the future. And far more irksome, you don’t know what the tax code will be next year, or over the next decade or two. That’s especially true now, because of the likelihood of a swelling budget deficit stemming from the Trump administration’s tax and budget policies.
Consider the budget negotiations underway in Congress. Will they mean higher or lower taxes in the future? There are major disagreements and it’s not clear how they’ll turn out. Yet this much seems evident: There is little appetite in the White House or Congress for short-term tax increases. So you may conclude that your taxes will stay the same or even be lower, and plan accordingly.
But not so fast. It’s easy to construct an argument suggesting that whatever happens this year, taxes must rise, and fairly quickly. After all, there are already signs that the bond market is reacting negatively to the prospect of ever widening federal budget deficits, which seem baked into every version of the Republican tax legislation now under consideration.
The deficit may become so high in the years ahead, in fact, that the United States may not be able to finance all of its debt cheaply. Moody’s said as much earlier this month, when it downgraded the credit rating of the United States, warning that political dysfunction is imperiling the nation’s financial future. It’s easy to imagine a pushback by financial markets so powerful that tax rates will need to increase in the future — even if Congress reduces them for most people now.
Thinking like this can give you whiplash. So what is a taxpayer to do?
In a word, diversify. Use a variety of off-the-shelf tax shelters available to people with no expectation of becoming a billionaire, and protect yourself against a range of outcomes.
That’s an idea that Joel Dickson, who heads tax planning at Vanguard, has studied and suggested for years. While I practice diversified investing avidly, I’m only beginning, belatedly, to contemplate what Mr. Dickson calls “diversifying your tax risk.”
“In many ways, taxes are not unlike investments,” Mr. Dickson said. “You don’t know what the future is going to hold but your wealth is tied to what the future will hold. So you diversify. Because you’re going to be wrong on some things, but you also know, that by diversifying, you will minimize your regret: You’re not going all in on what you might think could happen in the future. Instead you want to hedge that risk.”
That tax approach has always been recommended for extremely wealthy people and corporations, with high-powered lawyers and accountants at their disposal. But even if you work for a living and have a more modest income and savings, there may be tax planning moves available that could benefit you in the future.
Roths and Other Shelters
Diversification won’t protect you fully all the time, of course. In investing, for example, there have been periods — most recently, the high-inflation, high-interest-rate environment of 2022 — when stocks and bonds fell, domestically and internationally. But for the most part, the strategy has worked, generating reasonably good returns over long periods with far less volatility than if you had put all your money into the stock market — or into one stock that didn’t turn out to be a worldbeater.
Similarly, tax diversification means giving yourself options that will limit the damage, and, maybe, even help you prosper, whatever happens to the tax code. To the extent that you can control your own finances, it’s prudent to consider a variety of simple, widely available tax shelters, without depending totally on just one.
The broad concept is simple. The details, however, can give you a headache.
Mr. Dickson suggests spending some time exploring both traditional and Roth accounts in both 401(k)s and I.R.A.s. The traditional versions allow you to defer paying taxes on the income you put into the accounts — which makes sense if your tax rate will be lower later. The Roth versions require that you pay taxes now, which makes sense if your tax rate will be higher later.
There are some basic rules of thumb for which kind of account to emphasize at different stages of life. Typically, people’s earnings are lower earlier in their career, putting them into a lower tax bracket. So a Roth, which can also be drawn upon as an emergency fund, may be a better choice then. When your earnings are higher and you are taxed more heavily, the traditional version of 401(k)s and I.R.A.s may be more suitable.
But if you don’t know what the case will be, Mr. Dickson said, it may make sense to put some money into both versions.
Obviously, when it’s time to draw on the money you have been stashing away, it would be better not to have to pay taxes on it — which is the great advantage of a Roth. But Roths weren’t available until 1997, and people who entered the work force before then, like me, didn’t have a Roth option when we started out.
My own savings are skewed toward traditional accounts. But I expect to be putting more money into a Roth 401(k) — if only because of the Secure 2.0 legislation passed in 2022. It requires that “catch-up” contributions above the age of 50 — additional money, beyond the $23,500 permitted in tax-sheltered accounts in 2025 — go into Roth accounts starting in 2026. That requirement applies to “high earners,” which the law defined as those with incomes of at least $145,000 in 2023 dollars. Final regulations, and income thresholds for 2026, haven’t been completed.
Roger Young, a senior certified financial planner at T. Rowe Price, has studied the effects of Secure 2.0 and found that the law altered the calculus. “Roths look a bit more attractive now, even for many older people,” he said in an interview, particularly those fortunate enough to have put aside enough for retirement and to be looking for the best ways to bequeath retirement accounts to heirs. The Secure Act requires beneficiaries to spend down the assets in an inherited account within 10 years, which could mean hefty tax bills. Roth accounts sidestep these taxes for heirs.
Off-Brand Shelters
Education accounts known as 529s and the high-deductible health savings accounts known as H.S.A.s. can be used as tax-sheltered investment vehicles, and not just as tax-favored ways to save and spend on education and health, Mr. Dickson pointed out. “You’ll need to check the fine print, there are limitations on both of them but they are more flexible than you might expect,” he said. Under certain circumstances, for example, after all education expenses are paid, excess funds in a 529 account may be rolled over to a Roth I.R.A. account for the beneficiary.
Similarly, if you can afford to pay your immediate medical bills from other sources, you may want to treat the H.S.A. as a tax-deferred investment account. The money put into the account every year reduces your taxable income, much like the tax treatment of a traditional I.R.A. or 401(k). And if you use the H.S.A. money for nonmedical purposes, it will function roughly like a traditional retirement account, too: You pay taxes on the money as you use it. But if you save your medical receipts, you can withdraw money from the H.S.A. account in retirement, after its value has presumably appreciated, completely tax free. That makes this a sweet tax shelter, for those able to use it.
I’ll confess that these, and other approaches, don’t come naturally to me. I prefer simple solutions. And I’d rather focus on investing and core economic questions than on finding legal ways to minimize my tax bill.
For people with modest incomes, no single tax-planning strategy will protect you entirely from the vagaries in the tax code down the road.
But these are strange times. Diversifying among a variety of off-the-shelf tax shelters may put you into safer territory, whatever Congress does to the tax code, now and in the future.
Jeff Sommer writes Strategies, a weekly column on markets, finance and the economy.
The post Why Tax Shelters Aren’t Just for Billionaires appeared first on New York Times.
