Diversification now, more options later

Q I am getting conflicting advice in regard to taxable and non-taxable retirement accounts. I have heard it is smart to have pretax [401(k)] and after-tax (Roth IRA) accounts to keep yourself balanced in fear of uncertainty around future tax laws. However, I have the option through my employer to contribute after-tax dollars into a Roth 401(k). What's the smart move?

MIKE, SAVAGE, MINN.

A Congratulations. You are preparing for your financial future by putting money into your 401(k). Now, there's nothing wrong and much right about participating in a Roth 401(k) as well.

But I want to focus on an aspect of your question that has broad significance: tax diversification.

As you know, 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. It's a nice upfront tax break. However, you pay your ordinary income tax rate on the savings when it's withdrawn during retirement.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 advisers say stick with it if you believe your tax bracket will be lower in retirement.

With a Roth 401(k), your contributions are made with after-tax dollars. But the earnings on your contributions come out tax-free at withdrawal. The tax-free withdrawal of money during retirement is especially valuable if you anticipate that your tax rate will be higher when you're elderly than it is now. (By the way, the employer match is made with pretax dollars in a Roth 401(k). It grows in a segregated account and the match will be taxed at your ordinary income tax rate when it's taken out in retirement.)

The research I've looked at suggests that the tax-free withdrawal of investment gains from the Roth, whether in its IRA or 401(k) form, is extremely attractive. And the younger you are when you start making contributions the longer your money has to compound and (hopefully) the bigger the benefits of tax-free money.

Here's the thing: Who knows what tax brackets will be five or 10 years from now, let alone 30. Many people reasonably expect that taxes will be higher to pay for entitlements like Social Security and Medicare and government services. I'm in that camp.

Whether it's better to invest in a traditional 401(k) or IRA vs. the Roth IRA or Roth 401(k) also depends on whether your income is higher or lower several decades from now. Who knows? You can make an educated guess, but you can't get rid of the uncertainty.

These are two major reasons why I favor tax diversification. Another is that it adds to your financial options when it comes time to take money out in old age.

Chris Farrell is economics editor for "Marketplace Money." Send questions to cfarrell@mpr.org.

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