Tax Diversification with Roth IRAs

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When I was much younger and just started working, my dad introduced me to Roth IRAs. I was in my final year of high school (and first few years of college), working jobs where my income was reported, and he told me that we should put some money towards this retirement vehicle. As a typical high schooler, I didn’t really pay much attention but I made those contributions. It wasn’t until years later, after I graduated college and was working in the real world, that I realized the gift he had given me – I made several years of contributions at a tax rate of practically zero. The Roth IRA was very new then, it was created by the Taxpayer Relief Act of 1997, so few people knew about it. Fast forward fifteen years and while it’s more well known, it’s not well known enough.

That pushed my friend Jeff Rose to initiate a Roth IRA Movement, which this post is happily a part of. Here’s the slick little logo he made for it:

What is tax diversification? It’s thinking about your retirement in terms of the taxes you’ll pay and diversifying the accounts you use in order to reduce your tax exposure risk. In plain English, it means that we know what the tax rates are today but we don’t know what they will be in 10, 20, or 40 years. If they go up, then you “lose” in any tax deferred accounts like 401(k) and Traditional IRAs. If they go down, then you “lose” in any tax free accounts like a Roth IRA. If they remain the same, which is extremely unlikely given expiring deductions, credits, and other tax items; then it’s a wash.

Since you don’t know if they’ll go up or down, the best strategy is to diversify where you put your retirement savings so that you are reasonably protected against either situation. This is where the Roth IRA becomes very powerful and why I think it should be part of your retirement strategy. Most people point to the tax free nature of your contributions (you pay tax today, but you don’t on withdrawals) but that’s only beneficial if tax rates increase. It will hurt you if tax rates fall.

How to diversify? In an ideal world, I’d put half in a Roth IRA and half in a tax deferred account like a 401(k). Unfortunately, there are characteristics about Roth IRAs that make that nearly impossible for the duration of your working years. First, the contribution limits on Roth IRAs is much lower than a 401(k). IRAs have a contribution limit of $5,000 whereas 401(k)s allow contributions up to $17,000. That difference isn’t as significant as the income phaseout for Roth IRAs, which starts at $107,000 for single filers and $169,000 for married filing jointly. At some point in your professional career, you (or more likely, you and your spouse) will exceed the limits and not be able to contribute to your Roth IRA.

The big difference in limits and the phaseout makes it hard for you to go 50/50 your entire career, so I always suggest to max out your Roth IRA before you max out your 401(k). The order I suggest, and what I do myself, is to contribute to a 401(k) until I get the entire company match, max out the Roth IRA, then max out the 401(k).

Regardless of how you intend to contribute, keep taxes in mind and consider how you might limit your exposure to increasing or decreasing rates by diversifying your tax profile.

{ 9 comments, please add your thoughts now! }

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9 Responses to “Tax Diversification with Roth IRAs”

  1. rlaw100 says:

    Income brackets matter as well, as of right now I’m in the 15% bracket, but I intend to be making more later on. Paying my taxes now is beneficial to me to avoid the larger tax burden deferment creates later on if you move up in tax brackets.

  2. David S says:

    One thing to think about though, is that you actually get more money out of a Roth IRA than a Traditional IRA. The caps are 5k for either, so assuming you max them out and by time you retire they are worth 1 million. From the traditional you only get 750,000 while (assuming 25% tax bracket) but from the Roth you get 1,000,000. Yes you paid the same in taxes, but you saved more for use in retirement.

    • Anthony says:

      I agree with this line of thinking. Forget about what the tax rates are today or what rate they could be in the future.

      At the end of the day, the traditional IRA *will* be taxed once you start withdrawing. The Roth IRA will not.

      Also, the additional benefit of a Roth IRA is that you can withdraw your contributions any time you need. It can be set up as a sort of emergency fund.

    • uclalien says:

      This isn’t entirely correct. Assuming a 25% marginal tax rate, a person needs to earn $5,000 to put $5,000 into a Traditional IRA. That same person would have to earn $6,666.67 ($5,000/0.75) to put $5,000 into a Roth IRA. Short of having already maxed out every retirement savings option, there’s no reason why this person couldn’t take that extra $1,666.67 and put it toward retirement.

      So while the Roth may pay out more during retirement, this person has effectively paid for that larger return up front.

      • David S says:

        That is correct that you have to contribute more pre-tax income, however if you have 6666.67 to put in (after maxing out all other forms of retirement tax preferred accounts) you basically are allowed to save an additional 1666.67 a year by using the Roth and still get a tax benefit.

        Plus the other is physiological. You contribute 5k (post tax income) to a retirement account (By saving 5k throughout the year). In the case of the traditional you only see the 1666.67 come back as a reduction in your taxes, however in the Roth version you don’t see it come back but you don’t miss it either.

  3. eric says:

    Your dad is a smart man!

  4. Right on. This is the main benefit of Roth IRA. A lot of people think about diversification in terms of stocks/bonds and domestic/international. But you must diversify from a tax perspective also. I try to go 2:1 on my pre-tax to after-tax investments.

  5. Michael says:

    wow, I go 1:2 on my pre-tax to after-tax investments. I am in the 25% bracket, but I can’t see how tax brackets will remain with our national debt.

  6. NuView IRA says:

    Good strategy – to diversify where you put your retirement savings so that you are reasonably protected against any situation. Converting a traditional IRA to a Roth IRA is an appealing option for individuals who believe their retirement income will be taxed at a higher rate than their current income.

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