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The benefits of tax diversification

Chris Farrell Jan 28, 2011

Question: The company I work for just introduced the opportunity to choose a Roth option for our 401K investments. I’ve been working for ~19 years and have been maxing out my traditional 401K contributions ever since it was financially feasible (maybe 15 years?) I’ve also been investing in Roth but due to a late start combined with the ~$3K max my Roth accounts are much smaller than my traditional 401K. Does it make sense to now max out my 401K on the Roth side to balance out my tax liabilities when I retire? If not, any recommendations on how to split it up? Christine, Chicago, IL

Answer: I think it’s a good idea for you to participate in the Roth-401(k). You’ll pick up additional tax diversification.

The big difference between a traditional 401(k) and a Roth-401(k) is taxes. Your contributions to a 401(k) are made with pretax dollars. You pay your ordinary income tax rate on the savings when it’s withdrawn during retirement. The tax treatment of traditional 401(k)s is why many advisors say stick with it if you believe your tax bracket will be lower when you stop working.

With a Roth-401(k), your contributions are made with after-tax dollars. But the money comes out tax free at withdrawal. The tax free withdrawal is especially valuable if you anticipate that your tax rate will be higher when you’re older than it is now. (By the way, the employer match is made with pretax dollars. It grows in a segregated account and the match will be taxed at your income tax rate when withdrawn.)

Problem is, who knows what tax brackets will be 5 to 10 years from now, let alone 30 years. Will your income be higher or lower a decade or two from now? We can make educated guesses, but we can’t get rid of the uncertainty. That’s a good reason for favoring tax diversification. It adds to your financial options when it comes time to take money out in old age.

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