Here was the reader question that was asked by Raj Sharan, a financial writer for the Christian Science Monitor:
"I currently contribute about $20,000 a year tax deferred into a 401(k). My employer does not contribute. Since in the future (I'm 2 years from retirement) I'll roll this over into an IRA, would it be better to pay taxes now on the $20,000 and just invest in a regular account? Otherwise, when the money is withdrawn from an IRA, I'll be paying taxes on the entire investment as regular income, not just on the capital gains. I'm assuming that my tax bracket will be the same at retirement. A Roth 401(k) seems like a better deal, but my employer doesn't offer one."
Most investors, after relatively little study of investing, realize that diversification is an important principle. "Don't put all your eggs in one basket!" Pretty simple, right? Of course, loading up on tech stocks in the late 90s aside, most investors get this on some basic level. True diversification of non-correlating asset classes, without biases towards large U.S. stocks, is rare however.
Even if investors truly understand the principles of investing, another type of diversification has to be considered, especially as investors approach retirement: Tax Diversification.
So, here is my response to the question:
First, the client is correct, a Roth 401(k) would probably be the best deal. That not being an option, here are my thoughts.
The answer depends on the following factors: 1) how much do you currently have invested in tax-deferred accounts (401(k), IRA, other employer sponsored retirement plans) versus taxable accounts; 2) what are your spending plans in retirement (2 years from now). Here is why this information is important. The power of tax deferred growth is terrific, however, it is partially (or even entirely) offset by the lack of capital gains tax treatment, forced distributions at age 70½, and lack of step up of basis at death. Here’s how the earlier questions affect the ultimate answer.
(1) If the amount of the client’s assets currently in tax-deferred accounts exceeds the client’s anticipated spending needs over the course of the full retirement (i.e. until death), it would be excessive to add more to the 401(k). The reason is that at age 70½, when required minimum distributions begin, the forced distributions will cause unnecessary taxation at full ordinary income tax rates. Also, the taxable income that results can be a problem in overall tax planning, causing the loss of other deductions, or even sending the client into AMT land. In addition, if the amount in tax-deferred is not expected to be spent down during the client's lifetime, the balance at death will not receive a step up in cost basis. Thus, any assets in tax-deferred accounts at death are includable in the client's gross estate, subject to estate taxes, and taxable at ordinary income tax rates if the funds are withdrawn, even if it is to pay those taxes.
(2) If the plan is to spend much of the money that will be contributed to the 401(k) shortly after retirement, then it probably does not make sense to make contributions this close to retirement. The opportunity for tax deferred growth is little, and the tax treatment on distributions is brutal (see #1, above).
It's a bit cliche, but without knowing more about the client's situation, it is impossible to make a more specific recommendation. Here is where the tax diversification comes in. If the client is currently in a high tax bracket, and expects that to drop after retirement (this happens much less than people think), continued contributions to the 401(k) still make sense. If he is eligible to make Roth IRA contributions, that is preferable to his employer's 401(k), especially if he anticipates his tax brackets to remain the same or increase after retirement.
Remember that your tax bracket is not simply a function of your income today versus tomorrow. Tax brackets also change at the whim of Congress, both up and down. And believe it or not, Federal tax rates are currently low relative to historical U.S. tax rates, especially at the high brackets. Then again, what will they do to capital gains tax rates? Qualified Dividends? Estate taxes?
We all have our guesses, but your's is as good as mine. One way to handle these uncertainties is to diversify your assets among differently taxed buckets. We have found that the most effective way to do this is:
- Keep much of your appreciating (capital gain) assets in your taxable accounts. This effectively gives you some amount of tax deferral, and allows you to take full advantage of capital gains tax treatment. Of course, this is only effective with a long term buy and hold, passive investment strategy. If you, or your investment manager, is turning your portfolio over every year, you'll pay taxes every year anyway. Nonetheless, this will allow the highest expected growth assets to receive a step up in basis at death.
- Keep most of your fixed income allocation in your tax deferred accounts. This will allow you to seek the highest safe yield, without worry about current taxation. Long term growth expectations are lower compared to growth assets, reducing the impact of required minimum distributions and the loss of step up at death.
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