Roth, Traditional, or Taxable? Why Your Best Answer May Be 'Yes'
Tax diversification provides valuable control in retirement.
Note: This article is part of Morningstar's Tax Relief Week special report. A version of this article appeared on Feb. 14, 2013.
Although Roth IRAs have grown more popular since their introduction in 1999, just 8% of IRA holdings consist of Roth IRAs, according to Investment Company Institute data. The uptake of Roth 401(k)s has also moved fairly slowly. According to a 2009 Aon Hewitt survey, just 11% of 401(k) participants contribute to the Roth option.
It's easy to see why Roths don't get much love. They're the ultimate in delayed gratification because you pay taxes today in exchange for tax-free withdrawals down the line. And even if you don't give a hoot about your future tax rate or agree with the conspiracy theorists who believe a cash-strapped U.S. government could eventually decide to tax withdrawals on Roth accounts, traditional 401(k) contributions are certainly the more user-friendly choice. They're the default option if you don't make any 401(k) selections, and because your contributions aren't taxed on the way in, it's possible to amass an impressive sum more quickly. Seeing that investment kitty grow can provide positive reinforcement, prompting savers to sock away even more.
Black and White
It's also true that for many households, traditional 401(k) and even traditional IRA contributions are simply the smarter choice. For the many people nearing retirement who haven't amassed much in savings, they can reasonably expect to be in a lower tax bracket when they're retired than they are today. If that's the case, then paying taxes at today's rates--which you're required to do when you invest aftertax contributions in a Roth--is a bad bet.
On the flip side, Roth contributions will often be the better choice for younger savers who are ascendant in their careers and therefore apt to be earning much less today than they are in the future. Even setting aside the fact that taxes may well go up across all tax brackets down the line, young, upwardly mobile savers are likely better off paying taxes on their investment contributions in a lower tax bracket today than paying taxes at what may well be higher rates in the future.
Or Somewhere in Between?
For most others, however, a blend of all three major account types--Roth, traditional, and even taxable--will be the best bet. For starters, there's a big "who knows?" factor regarding future tax rates. Even if your taxable income is roughly the same in retirement as it is today, tax rates could still go up across the board--or vice versa. Tax diversification--like asset-class diversification--ensures that at least some of your assets will be well-positioned for the prevailing regime; you're not casting your lot with a single outcome.
And there's another important point in favor of tax diversification: control over your taxable income. The value of that control often gets lost in the shuffle prior to retirement because when you're working, you don't exert a whole lot of control over your tax bracket. Your income from your salary is what it is, and you're taxed on that amount, give or take a few credits and deductions here and there.
The same goes for people who come into retirement with all of their assets in traditional 401(k) and IRA accounts. True, they can cut way back on their traditional account withdrawals in the early years of their retirement and aim to get by on income from other sources, such as Social Security. But even that lever goes by the wayside once they hit required minimum distribution age, 70 1/2. At that point, they'll be required to withdraw their money on a preset schedule, and because the money is all taxable, they'll need to withdraw a higher pretax amount to meet living expenses than would be the case for someone withdrawing from a Roth IRA or taxable account. While they can reinvest their RMDs if they don't need them, as discussed in this article, the taxes never go away.
By contrast, people who come into retirement with a diversified pool of assets can pick and choose how much to withdraw from each account type each year, thereby exerting at least some level of control over their income and tax bracket. In turn, they can reduce the taxation of other sources of income that are not part of their personal retirement investments, such as Social Security.
For example, in a weak year for stocks, a retiree with Roth, taxable, and traditional assets could withdraw his RMDs from the traditional accounts while also raising additional cash for living expenses when engaging in tax-loss selling from the taxable account. He could use the tax losses to offset part of the ordinary income tax due upon the traditional IRA withdrawals and hold tax-loss carry-forwards in reserve to offset future capital gains from that account. Meanwhile, the retiree with 100% of his portfolio in traditional IRAs and 401(k)s wouldn't have the same type of flexibility; his only option would be to withdraw from the traditional accounts and pay the full taxes on those withdrawals.
The broad message is that unless your situation is one of these black-and-white examples, splitting your assets among Roth, traditional, and taxable accounts enables you to cope with a variety of tax climes. It also lets you pick and choose where you go for withdrawals, thereby minimizing the taxes you owe on your distributions from year to year.
If you're already retired and have the latitude to draw assets from vehicles with different tax treatments, it's worth checking in with a tax advisor to help strategize about where to go for income on a year-by-year basis. Although the sequence of withdrawals I discussed in this article provides a good starting point for such decision-making, methodically depleting each asset pool one by one--taxable, tax-sheltered, then Roth--won't necessarily be the most tax-friendly strategy. Keeping your asset pool diversified by tax status throughout retirement can help you exert a higher level of control.