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.