Weekend Reading: Limits of Tax Diversification and the Tax Alpha of Roth Optimization

Posted: 09/03/2021

|401(k) |Financial Planning |IRA |Tax

This article appears as part of Casey Weade's Weekend Reading for Retirees series. Every Friday, Casey highlights four hand-picked articles on trending retirement topics and delivers them straight to your email inbox. Get on the list here.

Weekend Reading

To Roth or not to Roth? This might be a question you’ve asked yourself before, and upon comparing a Roth IRA to a traditional IRA, what makes the most sense for your hard-earned dollars often comes down to taxes.

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Know the difference: My long-time favorite financial researcher, Michael Kitces, delves into the tax efficient tactics of Roth versus traditional IRA, and why you need to know the major differences between these two popular retirement savings vehicles. While often seen as having “unlimited” tax-free growth, it’s important to note that with Roth-style accounts, you pay taxes on contributions now, and receive tax-free withdrawals later. With traditional retirement accounts, you deduct contributions now, then pay taxes on withdrawals later.

Tax tactics: In weighing each option, the only way for both accounts to perform the same is if we don’t see any future tax rate changes, which according to experts, isn’t likely. In the event tax rates rise, the Roth IRA outperforms the traditional retirement account, but in the midst of uncertainty, another strategy has evolved. Kitces highlights a way investors can tax-diversify by splitting contributions between both accounts, in hopes of reaping a benefit from either, regardless of where future tax rates go.

At the same time, however, this doesn’t provide you with full capability of either account, and so, we are introduced to the concept of ‘Roth optimization’. With this strategy, you “time” your tax situation by contributing to a traditional IRA in high-income and high tax rate years – then, when tax rates are low, you switch to making Roth contributions.

Bottom line: Putting real thought and research into your planning can have a significant impact, especially when it comes to taxes. My favorite chart by far was the history of tax rates, which is the number one determinant of your decision. Personally, I view this as a synchronization of the highest marginal tax rate with our average effective tax rate. And with the prospect of higher taxes in the future, it only makes the case stronger for Roth.

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