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Tax Diversification with Roth IRAs

Posted By Jim On 03/27/2012 @ 7:00 am In Retirement | 9 Comments

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 [3] 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 [4] 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 [5] 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 [6], 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.


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[1] Tweet: http://twitter.com/share

[2] Email: mailto:?subject=http://www.bargaineering.com/articles/tax-diversification-roth-iras.html

[3] Jeff Rose: http://www.goodfinancialcents.com

[4] tax rates: http://www.bargaineering.com/articles/federal-income-irs-tax-brackets.html

[5] contribution limits on Roth IRAs: http://www.bargaineering.com/articles/ira-401k-hsa-contribution-limits-2012.html

[6] income phaseout for Roth IRAs: http://www.bargaineering.com/articles/roth-ira-contribution-limit-phaseout-calculator.html

Thank you for reading!