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Retirement Accounts: Diversifying for Taxes

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One of the big things you hear a lot about in investing is diversification of assets. Like the old advice, “Don’t put all your eggs in one basket”, the idea here is to spread your investment money among enough different assets so that if one loses money, you can still fall back on the others. We can look back to episodes like the Enron scandal, when some employees had their entire 401(k) invested in Enron stock and subsequently lost their entire nest egg, for evidence of why diversification is a good idea.

Although when we talk about diversification it is normally about what we are invested in, it is also worth considering diversifying where we are invested. Specifically, I am talking about the traditional IRA and 401(k) versus the Roth IRA and 401(k). With the traditional IRA and 401(k), you contribute with before tax dollars and pay tax on the principal and earnings whenever you withdraw from the account in retirement. With Roth, you contribution after-tax dollars and then withdraw both principal and earnings in retirement tax-free. The big difference is whether you pay taxes now or later.

In a perfect world where we know the future for a certainty, deciding where we should put our money is pretty easy. If our rate is higher now than in retirement, we use traditional retirement accounts. If our rate is lower now, we would use Roth accounts. Unfortunately, we don’t live in a perfect world and will never be able to predict these things for a certainty. Among the variables:

  1. If rates stay the same, will your income be higher now or in retirement?
  2. Will rates indeed stay the same, or will they increase? Will hell freeze over and rates be decreased?
  3. Will you retire in the same state where you have earned most of your savings? If so, will the tax rules and rates there change?
  4. Will the federal and state governments change the rules after the fact on the tax treatment of retirement account withdrawals in response to worsening economic conditions or the explosion of unfunded liabilities in entitlement programs?

Don’t fool yourself into thinking you know the answers to these questions, especially if you still have some time until retirement comes. We never know what life is going to bring, if we will be making as much on the eve of retirement as we do today. A job opportunity or family situation may convince you to move to a different state before you retire, which may have radically different tax structures. Imagine what an effect a move from Texas, where there is no income tax, to Massachusetts, where the unofficial state motto is “if you can dream it, we can tax it”, would have on your financial situation!

Questions #2 and #4 deal a little more with political risk. Do we know what the political winds will bring? Will the size of government continue to increase, and if so how will we pay for all of the services provided by government? My personal opinion is that our federal government is completely out of control with respect to spending, especially in entitlement programs. The taxes collected will not be enough to cover all of the promises that are being made.

Based on this reasoning, all else being equal tax rates would be higher in the future than they are now. Providing the rules do not change, it makes more sense to hold investments in Roth accounts since the tax benefit will be higher in the future than it is now. But what if things get really bad? Some promises made today may need to be broken, and who is to say that the tax treatment of Roth IRAs and 401(k)s as we know it today will be the same when it is time to retire? If things get really bad, it would likely be more politically viable for the government to take away money from those who have saved by declaring that Roth withdrawals are partially or fully taxable as opposed to raising taxes or breaking promises made through entitlement programs for those who have very little. I could easily foresee the day when Roth IRAs and 401(k) withdrawals are fully taxed simply because the government needs the tax revenue. In that case, it would make more sense to have invested in traditional 401(k)s and IRAs and claimed your tax savings on the front-end as opposed to investing in the Roth accounts with the promise of tax savings in the future that never materialize. In this scenario, a bird in the hand is worth more than two in the bush.

I don’t claim to know what will happen in the future, but as you can likely tell from my post I am not incredibly optimistic. What do I do, you ask? Most of most retirement money is currently in traditional 401(k)s, as that has been what was available. I also now invest in Roth IRAs (although the balances are small compared to the 401(k) plans) and am considering directing some money to a Roth 401(k), which our company just started offering this year. As with the uncertainty over the performance of different investments, we should also diversify for the uncertainty over the tax environment in the years to come.

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July 1, 2007 - Posted by | Retirement, Taxes

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