Q: Years ago, when our income was low, I bought into the idea of deferring as much ordinary income as I could. In hindsight that doesn't appear to have been a good decision. We traded being taxed at the time at a low rate on the ordinary income and a low rate on future capital gains derived from investments purchased with that income, for being able to invest the full amount of pretax income and being taxed in the future at high ordinary income rates and at higher ordinary income rates on the capital gains instead of capital gains rates. Even if deferring the income results in a lower ordinary income rate when it is later taxed, this may be offset by the capital gain being taxed at higher ordinary income rates. Please comment.
A: I have a couple of reactions to your question. First, when it comes to retirement savings, the key takeaway is extremely basic: Save. Take advantage of retirement savings plans. Tax treatment is an important but secondary issue.
Second, tax diversification pays for most of us. No one knows what tax brackets will be and what kinds of deductions and credits will be allowed in the tax code 10 years from now, let alone 20 or 30 years. The only safe bet is that Congress can't help but tinker with the rules and could even embrace major tax reform at some point.
What's more, most of us don't know what our income will be during our retirement years, especially if the time frame is 10 years or more from now. If you did, for instance, the decision to place savings into a traditional 401(k) or IRA or a Roth 401(k) or Roth IRA would be easy. (If income will be lower you'd favor traditional IRAs and 401(k)s, and if higher the Roth versions.)
The uncertainty is why tax diversification is a smart move. It adds to your financial options when it comes time to take money out of retirement savings. Ideally, you'll have some money in tax-deferred accounts, some money parked in Roth-type savings, and the rest in taxable savings. (Depending on the type of savings, taxable accounts offer the advantage of controlling when you pay capital gains or the option to harvest tax losses.)
The closer you get to the traditional retirement years, the more you should have a realistic grasp of your household spending and income flows, making it easier to adjust the "tax mix" in your favor.
Chris Farrell is senior economics contributor for American Public Media's Marketplace and economics commentator for Minnesota Public Radio.