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Tax Diversification When Investing

Written by Nickel - 7 Comments

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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?

Published on October 28th, 2009 - 7 Comments
Filed under: Retirement,Saving & Investing,Taxes

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

Comments (scroll down to add your own):

  1. 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.

    Comment by Anonymous — Oct 28th 2009 @ 11:00 am
  2. 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.

    Comment by Anonymous — Oct 28th 2009 @ 1:27 pm
  3. 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.

    Comment by Anonymous — Oct 28th 2009 @ 1:51 pm
  4. 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.

    Comment by Anonymous — Oct 28th 2009 @ 10:06 pm
  5. It’s going to be end of mine day, except before finish I am reading this impressive post to increase my experience.

    Comment by Anonymous — Jul 8th 2013 @ 12:30 pm
  6. Great beat ! I wish to apprentice while you amend your web site, how can i subscribe for a blog site?
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    Comment by Anonymous — Jul 10th 2013 @ 1:47 pm
  7. 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.”

    Comment by Anonymous — Sep 30th 2013 @ 1:49 am

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