Tax Diversification When Investing

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?