Tax diversification

Pay taxes today? Or later?

Should you pay taxes today by making Roth contributions to your plan or stick with pre-tax contributions, where you postpone paying taxes today but owe them in retirement? As always, it depends.

  • If you think your tax rate will be lower in retirement, it's better to stick with pre-tax contributions. That way you'll postpone paying taxes until retirement, when you expect to be in a lower bracket.
  • If you think your tax rate will be the same or higher in retirement, it's better to go with Roth contributions. That way you'll be paying taxes at a lower rate today.

Of course, no one knows exactly what your tax rate will be in retirement. It depends on so many things—your income, family status, retirement benefits—and even government tax policy.

The answer: Tax diversification

What can you do in the face of this uncertainty? Do what you already do when dealing with investment uncertainty: Diversify. Consider holding both pre-tax and after-tax savings in your retirement account. That's known as tax diversification.

Pursuing a policy of tax diversification could be wise for many participants. That said, there are certain situations where it's an especially good idea and some cases where it makes less sense.

If you are financially well-prepared for retirement, Roth contributions make sense. Strong savers and those with generous retirement benefits may have a sizable retirement income—and be subject to sizable taxes. Having Roth savings exempt from taxation would be a boon.

If you're not as well-prepared for retirement as you'd like, pre-tax contributions make sense. Your income—and tax rate—are likely to drop in retirement. By making pre-tax contributions, you'll avoid paying taxes at a higher rate today and pay them at a lower rate in retirement.

Is Roth right for me?

Who might benefit Why
You are financially well-fixed for retirement (high savings, good benefits). Chances are you'll be in the same or a higher tax bracket in retirement. Any Roth savings would be exempt from taxation.
You contribute the maximum to your employer's plan.* Switching to Roth contributions increases your tax-advantaged savings. For example, if you contribute $18,000 on a pre-tax basis, you will owe taxes on this amount, plus any earnings, in retirement. Contribute $18,000 on a Roth basis instead, and all of it will be tax-free in retirement.
Your income prevents you from contributing to a Roth IRA.** You can obtain the advantages of Roth contributions within your plan, which has no income restrictions comparable to those of the Roth IRA.
You don't earn a lot today—but just wait. Your career is just getting started. You expect your income—and tax rate—to rise in the years to come.
You pay taxes at a low rate today (10% or 15%). Making Roth contributions to your plan account would cost you little today and could result in tax savings in retirement.

*The maximum plan contribution is $18,000 annually in 2015, or $24,000 if you're age 50 or older and your plan allows catch-up contributions. If you contribute to a governmental 457(b) plan allowing for Roth contributions, your plan may allow a special catch-up contribution in the three calendar years before you reach the plan's normal retirement age.

**To contribute to a Roth IRA, your modified adjusted gross income cannot exceed $193,000 for married taxpayers filing jointly or $131,000 for single filers in 2014.

Who might not benefit Why
You're behind on saving and expect Social Security to be the mainstay of your retirement. Chances are your income will fall in retirement. Consequently, you'll be in a lower tax bracket.
Your pay spikes thanks to big commissions or bonuses. Your tax rate may be higher this year than in retirement. So you’re better off deferring taxes now with pre-tax contributions and paying at a lower rate later.
You have children, a family income generally between $20,000 and $50,000, and you receive the earned income tax credit or the additional child tax credit. If you switch to Roth contributions it would raise your taxable income and could cost you these valuable tax credits. These credits are more valuable than the Roth option would be to you.

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