Traditional IRAs and Roth IRAs: Invest in Both to Diversify Your Tax Risk

In both Retirement Smackdown: Which is Better -- Traditional IRA or Roth IRA? and More on Traditional IRAs Versus Roth IRAs we all discussed the pros and cons of Traditional IRAs and Roth IRAs to try and determine which one was better. In the end, it came down to whether you believed your taxes would be higher in retirement than they are now as to which option was generally better. Predicting future tax rates and well as your income in later years is quite difficult to say the least, so we were at a standstill.

Then, some of the commenters on More on Traditional IRAs Versus Roth IRAs suggested a couple different thoughts -- both of which seemed like great ideas to me. The first was to invest in both a traditional IRA and a Roth to diversify your tax risk. Here's the comment that got things rolling:

Opt for tax-diversity--contribute to both. It seems a lot like guessing to me. Factor in that long-term capital gains (taxable) rates are low, low too, and the picture is even muddier.

This thought was seconded as follows:

I agree with the tax diversity. I asked a CPA on this one as well and I felt that his answer was very good. He said he had worked back in the 1970's when the marginal tax rate was 70% and everyone thought it was going up. If Roths had existed then high income people would have been screwed even though they were listening to sound advice. He mentioned that a bird in the hand is better than two in the bush, basically take the tax break now instead of trying to game the system, because congress could very well repeal Roth tax free status later anyway.

With that being said, I am just starting my career so I want to take advantage of this. My company offers a Roth 401k, but our match is a normal 401k match. This is perfect for me, because it basically splits me between the two theories effortlessly.

There were a few more comments along these lines, but they all point to the same issue: since we don't know what future taxes will bring, let's diversify our investments, putting some into a Roth and some into a traditional IRA. Seems like a logical idea to me.

And then another thought came up, one which, in part, will help people contribute to both types of IRAs we're talking about here. The suggestion:

I agree with the first comment and the last line in FMF's post. Invest in both to hedge against what a future congress will do. Although uncommon, congress has passed laws that retroactively change tax rules (upping the age of the kiddie tax from 14 to 18 comes to mind); so tax planning where you don't reap the benefits decades later carries some risk. Investing in the trad IRA gives you an immediate benefit that you can turn around and invest in the Roth correct?

In my situation, my spouse is a homemaker and we're in the middle of the 28% bracket. Investing up to the max deduction in trad IRA ($4000 for 2006) gave us an extra $1000+ (from the tax deduction) to invest in a Roth.

Great idea, huh?

Comments

[Matt]

I don't think the final commenter's suggestion is a great idea (as implemented) since you can only contribute a max of $4000 ($5000 next year) to the sum of your IRA's. Now if he's talking about putting $4000 in a trad IRA for himself and using the deduction to fund his wife's IRA, then it is ok.

Frankly, for people with 401K's, diversification would suggest you put all your IRA contributions to a ROTH since the 401K has the same tax treatment as a trad. Basically, pick a percentage of your income to save, invest in the 401K up to employer match and put the remainder in your Roth. Now you're tax diversified.

[Dave]

Are there any IRS rules limiting one's ability to do both IRAs?

[Matt]

The only rules are that you can contribute a max of $4000 ($5000 in 08) to both IRA's. Meaning you can go $2000/$2000 or $3000/$1000 but not $4000/$4000.

Your income also determines your eligibility for contribution for a Roth (I think its an AGI of more than $160000 for a married filing jointly). If your income is above the limit, you can only contribute to a traditional.

[Patrick]

Matt beat to to my point. I invest heavily in my 401k (more than IRA limits), so I max out my Roth IRA for diversification. If all you do is invest in the IRA and not in the 401k, 403b, etc, then investing in both makes sense for tax diversification.

[Brandon]

A lot of people forget that Roth IRAs have a higher effective contribution limit. Roth IRA's essentially permit contribution of $4000*(1-marginal tax rate) in pre-tax dollars compared to a only $4000 in pre-tax dollars for a deductible Traditional IRA. Therefore a person in the 25% tax bracket can contribute up to $5333 in pre-tax dollars to a Roth IRA compared to only $4000 in Traditional IRA. It's not the only consideration, but it's important for those who do max out their contributions every year.

[Brandon]

Oops. It should be $4000/(1-marginal tax rate) in pre-tax dollars for Roth IRA's. Sorry...