In today's
financial world, diversification is a common buzzword. Most investors
understand the importance of spreading their assets across multiple asset
classes to reduce market risk. The old saying, "Don't put all your eggs in one
basket," still rings true when it comes to investing in stocks, bonds, and
other securities.
However, while most investors recognize the importance of investment diversification, many overlook another crucial form of diversification: tax diversification. Just as market fluctuations can affect your returns, tax policy shifts can significantly impact how much of your retirement income you keep. The key to managing this risk? Having flexibility in how your retirement income is taxed.
Traditional 401(k)s: The Popular (but Taxable) Retirement Vehicle
Most
employers offer a Traditional 401(k) as the primary workplace retirement plan.
Contributions are made pre-tax, lowering the employee's taxable income in the
year of the contribution. In addition, employer matches are also tax-deductible
for the company. This setup is seen as a win-win: employees get an immediate
tax break, and employers receive a deduction while providing a valuable
benefit.
However,
there's a catch.
When the employee eventually retires, every dollar withdrawn from a Traditional 401(k) is treated as ordinary income and taxed accordingly. For many retirees, this can come as a shock—especially if they assumed they'd be in a much lower tax bracket in retirement.
Are You Really in a Lower Tax Bracket in Retirement?
The
conventional wisdom is that workers are in higher tax brackets during their
careers and will drop into lower brackets in retirement. While this may be true
for some, it's far from guaranteed.
Let's look
at the historical context. Over the last 100 years, the top marginal federal
income tax rate in the U.S. has varied significantly:
- In the 1940s and 1950s, the top
rate exceeded 90%
- In the 1980s, it dropped to 50%
- As of 2024, the top rate is 37%
for income over $609,350 (single) or $731,200 (married filing jointly)
(Source: IRS.gov - Tax Brackets for 2024)
The federal
government currently faces a ballooning national debt—over $34 trillion—and net
interest payments on that debt are projected to be the third-largest federal expenditure
by the early 2030s, after Social Security and Medicare
(Source: Congressional Budget Office, 2024).
So, will tax rates go up in the future? No one knows for sure, but the fiscal pressures suggest it's a real possibility. If rates rise, retirees relying solely on tax-deferred accounts may face larger-than-expected tax bills in retirement.
Roth 401(k): A Tool for Tax Diversification
Enter the
Roth 401(k).
Unlike
Traditional 401(k)s, contributions to a Roth 401(k) are made after-tax, meaning
you don't get a tax deduction up front. But the trade-off is significant:
qualified withdrawals in retirement are entirely tax-free, including both
contributions and investment gains.
If your
employer offers a Roth 401(k) option, contributing to it could be a smart way
to diversify your future tax exposure. Here's why:
- If tax rates are higher in the
future, you've already paid taxes on your Roth contributions at today's
(lower) rate.
- In retirement, you can strategically draw from both Traditional and Roth accounts, choosing which account to tap based on your tax bracket, other income sources, and overall tax strategy.
The Cost of Taxable Withdrawals
Let's
illustrate this with an example:
- If a retiree is in the 10% tax
bracket and takes a $10,000 distribution from their Traditional 401(k),
they owe $1,000 in taxes.
- But if they're in the 37% tax
bracket, that same $10,000 withdrawal results in a $3,700 tax bill.
- Alternatively, withdrawing
$10,000 from a Roth 401(k)—assuming it's a qualified distribution—results
in no taxes owed.
This flexibility is particularly useful if you receive Social Security benefits, pension income, or have Required Minimum Distributions (RMDs) from traditional retirement accounts after age 73 (age 75 starting in 2033, per the SECURE Act 2.0).
Should You Do a Roth Conversion?
Some
investors consider a Roth conversion, which involves moving funds from a
Traditional IRA or 401(k) into a Roth account. This requires paying taxes on
the converted amount in the year of the conversion but allows the money to grow
tax-free going forward.
Here are 3
key factors to evaluate before doing a Roth conversion:
- Can
you afford the tax bill now?
Conversions can significantly increase your taxable income for the year. It's ideal to pay the taxes with outside funds, not from the converted amount. Conversions can significantly increase your taxable income for the year. It's ideal to pay the taxes with outside funds, not from the converted amount. - What's
your time horizon?
The longer the money has to grow in the Roth account, the more you may benefit. Roth conversions are often more favorable 20+ years before retirement. The longer the money has to grow in the Roth account, the more you may benefit. Roth conversions are often more favorable 20+ years before retirement. - Do
you expect higher tax rates in the future?
If yes, paying taxes today could be a smart long-term move.
If yes, paying taxes today could be a smart long-term move.
Keep in mind: Roth conversions cannot be undone (the recharacterization option was eliminated by the 2017 Tax Cuts and Jobs Act).
Build Flexibility into Your Retirement Plan
The best
approach for most investors? Diversify. Just as you diversify your investment
portfolio, diversify your tax exposure.
If your
employer offers both Traditional and Roth 401(k) options, consider contributing
to both. A common strategy is to:
- Make employee contributions to
the Roth 401(k) (after-tax)
- Receive employer match in the
Traditional 401(k) (pre-tax)
This setup
allows you to build a tax-diversified retirement nest egg. In retirement,
you'll have options, which is one of the most powerful tools for tax
efficiency.
