Traditional + Roth = Tax Diversification

by Michael on Jan 9, 2013 · 7 comments

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If you listen to the vast majority of personal finance gurus, you’ll come away with the impression that Roth accounts are the best thing since sliced bread.

While I do appreciate the advantages of Roth accounts, traditional (tax-deferred) retirement accounts don’t get nearly enough credit.

The reason I say this is that having a combination of traditional and Roth funds at your disposal provides you with flexibility and (tax) diversification.

Yes, it’s great to put money into a Roth, pay taxes now, and get everything out tax free on the back end. But it’s important to keep in mind that traditional retirement accounts provide a means for avoid all taxes on at least a portion of your money.

Confused? Here’s what I mean…

Note: For the sake of simplicity, we’ll use the 2012 tax situation since 2013 is still being sorted out in the wake of the fiscal cliff.

Consider the case of a married couple filing jointly. Assuming that they have a portion of their money in tax-deferred retirement accounts and a portion in Roth accounts, they can withdraw a sizable chunk of money from a traditional account, pay little or no taxes, and top off with Roth funds.

In fact, thanks to the standard deduction ($11,900) and the personal exemptions ($3,800 x 2) they can withdraw $19,500 tax free. That’s completely tax free since they never paid taxes on the contributions in the first place.

Here are three simple scenarios that illustrate my point:

  • $19,500 in taxable income with $0 in taxes
  • $36,900 in taxable income with $1,740 in taxes (10% of $17,400)
  • $90,200 in taxable income with $9,735 in taxes (above + 15% of $53,300)

That works out to an effective rate of 0%, 4.7%, or 10.8%, respectively.

Not bad, huh?

Sure, income tax rates might (and quite possibly will) go up in the future. But that’s the beauty of this approach. By having a combination of traditional and Roth funds, you can calibrate the distributions to minimize your tax hit.

Take traditional distributions to fill up at least the 0% space, if not the next bracket or two, and then top things off with Roth funds as necessary.

Keep this in mind the next time you hear a so-called expert espousing the virtues of a Roth IRA, 401(k), or whatever.

1 Kurt @ Money Counselor January 9, 2013 at 11:23 am

I think you’re right on. Only those who can demonstrate the ability to predict the future perfectly should eschew diversification!

2 The College Investor January 9, 2013 at 11:37 am

I’m a Roth fan because I do believe that taxes will rise in the future. But you’re also correct, and I should reconsider, will the 0% or even the 10% tax bracket really rise? I can see higher tax brackets rising, but I don’t know about the lower tax brackets. Good point!

3 krantcents January 9, 2013 at 7:25 pm

Although I expect to be in a lower tax bracket when I retire, I am hedging my bet by investing in a Roth IRA.

4 Leah January 9, 2013 at 8:48 pm

I like tax diversification. Everyone thinks they know what will happen in the future, but you really can’t possibly know for sure. Do both and you’re covered no matter what the outcome. It’ll be fun to see what the better answer is 20, 30, or more years from now.

I love that quote by Mark Twain, “whenever you find yourself on the side of the majority, it’s time to stop and reflect.” With all the hoopla around Roth’s, I think it’s time to pause and reflect, too!

5 Michael January 9, 2013 at 10:06 pm

krantcents: Even if you’re in a lower tax bracket at retirement, nothing beats paying no taxes, ever — which is exactly what you can pull off on a portion of your retirement stash if it’s in a traditional account.

6 Evan January 12, 2013 at 11:55 am

I think the same basic argument can be made about investment styles and products as well. I know most people don’t agree but I like my cash value life insurance policy b/c when I am 60 or 65 and if the market hits the fan that year I can pull from that allowing my investments to recover.

7 JS January 14, 2013 at 6:21 pm

While it’s relatively rare these days, for those of us with a defined-benefit pension, we need to take into account how those distributions play into it. For example, personally I expect a pension that will fill up most of my low brackets so Roth makes more sense from me.

A person though should also take into account any tax benefits that he can/does take advantage of with income phase outs (e.g. Roth IRA, child tax credit). In some cases, pre-tax (non-Roth) contributions are necessary to keep “income” low enough so you don’t phase out (or phase out less).

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