Taxes are a huge consideration when planning for retirement. As you’re building up your nest egg, one of the big decisions that you’ll face is whether you should put your money in a traditional, tax-deferred account or a Roth-style account.
Of course, we don’t all face this dilemma. After all, access to Roth IRA accounts is limited by income (but see here and here), and access to a Roth 401(k) or Roth 403(b) is limited by whether or not your employer offers one. Many don’t, even if they offer tax-deferred versions of these accounts.
But what if you do have access to Roth accounts? How do you decide where to put your money? What follows is a quick overview of the major issues.
The tax deferred option
One of the biggest arguments in favor of using tax deferred accounts is that you’ll get your tax savings up front. These guaranteed savings can help those with limited means save/invest more money than they might have otherwise.
Taking an immediate tax break might also be a good option if you’re in a relatively high tax bracket. After all, if your income falls in retirement, you’ll have dodged higher taxes during your earning years in favor of lower taxes in retirement.
But what if tax rates increase dramatically between now and retirement? Even if you fall to a lower bracket, the applicable rate might wind up being higher. In that case, you’d have traded lower taxes during your earning years for higher taxes in retirement.
Another downside to tax-deferred accounts is that they effectively convert capital gains (currently tax at a favorable rate) into regular income. This is a very important fact to consider when deciding where to hold certain investment types.
The Roth option
Roth accounts make the promise of completely tax free withdrawals in the future in return for paying your taxes right now. This is a particularly good option if you expect to be paying higher taxes in retirement than you are right now.
Another risk that you’re running by using a Roth account is that Congress might change the rules. I currently view this as rather unlikely, but consider (for example) what would happen if we would adopt something like the Fair Tax between now and when you retire…
In such a case, you would have paid full income tax on your Roth contributions, and then you would be taxed again in retirement when you spend this money. Double taxation. Yuck.
What are we doing?
So how have we solved the problem? As with all things that involve uncertainty in the investing world, we’ve decided to diversify our risks. I honestly have no idea what will happen with tax rates going forward, and I can only project what our income might look like in retirement.
In view of these uncertainties, we’re taking advantage of both tax-deferred and Roth investment accounts. In doing this, it’ll be impossible for us to be 100% right, but we also won’t be 100% wrong. Given that we have both account flavors (not to mention a taxable investment account) at our disposal, we’ve given a lot of thought as to optimal asset locations.
In short, we keep our most tax inefficient investments in retirement accounts, with those with the highest expected rate of return in Roth accounts. Our taxable account, on the other hand, is loaded up with tax efficient investments.
What about you? If given the choice, how would you proceed?
7 Responses to “Tax Diversification When Investing”
Before you allow yourself to get too embroiled in the fine points of the tax code, remind yourself that “tax reduction is a means to an end, your life goals, not an end in itself.”
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I’m planning to inquire this year at the company retirement accounts meeting if any roth 401ks are in the works. Currently at age 29 I am putting enough into 401k to get the match and paying down debts that have potential to cost me alot.
Ultimately I want to have enough in tax-deferred accounts to at least fill out my tax-free income when I retire. There is always the option of converting to Roth in a recession when the account is worth less and so pay taxes on the reduced amount.
I can’t believe income or capital gains taxes are ever going to be lower than under the last Bush administration, so I favor the Roth – but in reality, with the annual limit on Roth contributions, what we do is “all of the above” – 401k (gotta get the employer match), Roth, and straight-up equity and bond investing.
I think I’d prioritize them in that order – 401k to at least maximize any match you can get, Roth to the annual limit, anything left over in a brokerage account.
Nice post and spot on with the tax diversification among account types. Generally speaking, it is safe to assume that if you have a modest projected retirement income that would land you in the lower tax brackets today (15% or less that is), you’ll be able to put more into the pre-tax 401k/403b/SIMPLE/SEP/457/etc. The closer you get to middle income brackets and above, the more valuable the Roth IRA becomes.
I like the Roth option for the reasons mentioned above. I expect to pay higher taxes in the future as should everyone cause they always are increasing. Also mentally you don’t have to worry about what % will be taken out down the road.