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Tax Diversification: Roth IRA vs. Traditional IRA

If you’re eligible to contribute to either one, the “Roth IRA vs. traditional IRA” decision is primarily determined by one question:

Do you expect to be in a higher tax bracket when you withdraw the money than you’re in now?

  • If the answer is yes, then a Roth IRA is better (because the benefit gained from a Roth–tax-free distributions in retirement–will be more valuable than the benefit gained from a traditional IRA–a current deduction).
  • If the answer is no, then a traditional IRA is better (for the opposite reason).

The catch, of course, it’s that it’s quite difficult to predict your future tax rate. I’d argue that it’s downright impossible if you’re more than a couple decades away from retirement.

Case in point: For those of you who were working in 1979, did you guess your 2009 tax bracket correctly?

Oops, I guessed wrong!

If you do all of your investing via tax-deferred accounts–such as a 401(k) account or a traditional IRA–and you end up in a higher tax bracket in retirement than you’re in now, then you guessed wrong. You would have been better off putting a portion of your money into a Roth.

And it’s worth noting that the more you have invested in tax-deferred accounts, the higher your taxable income–and tax rate–will be in retirement. In other words, the more you put into a traditional IRA or 401(k), the more attractive a Roth IRA becomes.

Conversely, the more you put into a Roth IRA or Roth 401(k), the more attractive traditional IRA and 401(k) accounts become.

Tax Diversification: A little bit of both.

The idea of tax diversification is simple: Do a little bit of both. Put some money in tax-free accounts and some money in tax-deferred accounts. This minimizes the risk of incorrectly guessing your future tax rate.

One practical way to tax diversify is to prioritize your investments as follows:

  1. Contribute enough to your 401(k) to get the full employer match,
  2. Max out your Roth IRA,
  3. Go back to your 401(k) and max it out,
  4. Invest via taxable accounts.

Also, by tax diversifying, you give yourself the ability to strategically plan your IRA and 401(k) distributions in retirement. For example, each year, you could take sufficient distributions from tax-deferred accounts to put yourself at the very top of your current tax bracket, at which point you could switch over to distributions from your Roth in order to avoid a higher tax rate.

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Comments

  1. Any thoughts on how to mix in the Roth 401k?
    What do you think #4 being life insurance instead of the taxable account?

  2. Another advantage of having some money in a Roth IRA is no minimum required distributions. You could choose to leave those tax free investments to your children.

    -Rick Francis

  3. EoW:

    To me, if you have a Roth option in your 401k, it just goes in step #3. When going back to max out the 401k, put some of it in Roth, some of it in traditional. (Of course, this is just a rough guideline. If a person has a reasonable degree of certainty that their tax bracket will be higher/lower in retirement, then it may make sense to do all Roth or no Roth in the 401k.)

    As to life insurance, I have yet to see an insurance product that I’d recommend over simply using ETFs in a taxable account for most investors, though a) I suppose that could change, and b) that doesn’t apply to every single situation.

  4. The key to the Roth decision is not if you think your tax bracket will be higher. The important thing is if you “know” your tax bracket will be higher. For over 95% of savers, paying the taxes up front rather than deferring them compounds the risk that they will have insufficient retirement income. Only after that risk has been eliminated should one consider a Roth.

  5. One issue that was not mentioned, political risk. Will our government change the rules on us mid-stream? This is one risk with going with a Roth IRA, you assume the government will keep it not taxable. If not directly, it’s possible indirectly.

    This was just discussed in the comments section of the WSJ:

    http://online.wsj.com/article/SB126004888014078557.html#articleTabs%3Dcomments

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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