Saving for Retirement

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Crystal ball cloudy? For IRAs, consider tax diversification

June 03, 2013

It's been said that one of the two things that are certain in life is taxes. What the aphorists never provide, though, are the details. Understandably so: The push and tug of politics can make future tax rates unpredictable—as the "fiscal cliff" drama of late 2012 reminded us yet again.

Knowing what future tax rates will be would make life easier for retirement savers who wonder whether to contribute to tax-deductible traditional IRAs or to Roth IRAs. When it comes time to withdraw from an IRA, one type of account can be superior to the other, depending on what those future rates turn out to be.*

The same dilemma applies to those saving in tax-advantaged "defined contribution" employer plans—such as 401(k), 403(b), and 457 plans—who are considering whether to contribute to a Roth 401(k) plan, if available.

And then there's the question of whether to convert an existing account to a Roth IRA or a Roth 401(k). An insight into the future would help here, too.

What would you do with an extra $621?

Whichever type of IRA you choose, the goal is the same: Maximize potential after-tax wealth by minimizing the tax bite. But less-visible investment costs can also siphon away investment earnings.

For example, say the balance in your IRA is $67,438. This odd amount was the average IRA account balance in 2010, the most recent figure available from the Employee Benefit Research Institute. You can invest the balance in a hypothetical low-cost fund or a hypothetical high-cost fund. If all else were equal, you'd save $621 a year with the low-cost fund.

Here's the math. The low-cost fund's cost is $128, based on the average expense ratio for Vanguard funds in 2012 ($67,438 x 0.19%). The high-cost fund's cost is $749, a figure derived by using the mutual fund industry's average expense ratio for 2012, according to Lipper ($67,438 x 1.11%).

If you found yourself $621 "richer," it might be a little easier to pay for a weekend getaway, your average cable bill for a year, a pair of higher-end designer shoes, a tablet, or a dirt bike. Or you could save the savings: $621 invested every year for 20 years would grow to $21,604 if compounded at a hypothetical annual return of 5%.

In other words, costs matter. You can easily check out what a fund's costs are by visiting the company's website.

But what do you do if your crystal ball is cloudy, as most are? You could consider diversifying the tax treatment of your retirement accounts. 

Three "ifs"

The first step is to understand the IRS rules.

If a tax-deductible traditional IRA is of interest, you must meet income (and other) requirements: Details are at vanguard.com/whichira. With this type of IRA, contributions reduce your taxable income and taxes on earnings are deferred. When you withdraw from the account in retirement, you'll pay taxes on both the original contribution and the earnings. The same tax-treatment rules apply to tax-deferred employer plans.

If your income level disqualifies you from a deductible IRA, you can contribute to a "nondeductible" version. As its name implies, your contribution is after-tax; that is, it doesn't lower your taxable income. Taxes, however, are deferred on earnings in the account until withdrawal.

If your income meets the guidelines for a Roth IRA, or if your employer plan includes a Roth option, you would also contribute with after-tax dollars. But you'd owe no taxes (including the new Medicare surcharge) on qualified withdrawals. And you won't have to take "required minimum distributions" from your Roth IRA after reaching age 70½, or from your Roth 401(k) if you roll it over to a Roth IRA. 

Three more "ifs"

If you believe your tax rate will decline in retirement, a traditional deductible IRA would be best. By reducing your taxable income, you'd minimize what you owe at the higher current tax rate and withdraw funds at a lower tax rate in the future.

On the other hand, if you believe that your tax rate in retirement will be the same as now or higher, consider a Roth IRA. You'd pay taxes on your income at the current rate and fund the IRA with after-tax dollars. But there would be no taxes on withdrawals.

Maria BrunoBut if you don't have a strong view about future rates, you may want to diversify by holding both types of IRAs. "Future tax rates, like market performance, are difficult to predict accurately," says Maria Bruno, a Vanguard investment analyst. "That's why an approach that combines both traditional and Roth accounts is worth consideration. In retirement, you could then withdraw from whichever account minimizes the tax bite in any given year."

A conversion conversation

The least painful way to achieve tax diversification is by setting up the accounts you want and contributing to them; you can have more than one type. Another option is to convert an existing tax-deferred retirement account to a Roth (assuming, in the case of employer plans, that this option is available).

For individual accounts, there are no income restrictions on the ability to convert some or all of a traditional IRA to a Roth. If you don't qualify outright for a Roth, a two-step maneuver allows you to open a "backdoor" Roth IRA: First contribute to a nondeductible IRA; then convert it to a Roth.

The newest change, in January 2013, allows you to convert some or all of your balance in a tax-deferred employer retirement plan to a Roth 401(k). Be aware, however, that this is likely to be a distant choice: Plan amendments are required, which may not be implemented soon.

There is a price for conversion: taxes.

If you are converting an IRA or employer-plan account that has been funded with pre-tax contributions, you'll owe tax on the amount converted. For backdoor Roths, no tax should be due on the conversion amount, assuming the conversion was done so quickly that earnings did not accrue. However, if you own other IRAs that you aren't converting, you will owe tax based on a proration that factors in the balances in your other tax-deferred IRAs, including traditional, SEP, and SIMPLE IRAs, but not inherited IRAs.**

"To get the most benefit from a conversion strategy," Ms. Bruno cautions, "you should pay the tax bill with funds outside of your retirement accounts."

To Roth or not to Roth? That is the question 

How does today's tax rate compare with the tax rate you expect when you make withdrawals? Here's a rule of thumb.

Higher today Consider a pre-tax traditional IRA or tax-deferred defined contribution plan account.
Lower today Consider a Roth IRA or a Roth 401(k), if available.
Uncertain Consider diversifying between account types.

Source: Vanguard.

* Withdrawals from a Roth IRA or a Roth 401(k) are tax-free if you are over age 59½ and have held the account for at least five years. Withdrawals from an individual Roth IRA taken prior to age 59½ or if you have held the account less than five years may be subject to ordinary income tax or a 10% federal enalty tax, or both. For withdrawals from a Roth 401(k) taken before age 59½ and less than five years from the first contribution, the portion of the withdrawal that is attributable to earnings would be subject to ordinary income tax and a 10% federal penalty tax.

**Coverdell education savings accounts are not mentioned because they are not technically IRAs. They are intended to support saving for education, not retirement. 

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest
  • We recommend that you consult a tax or financial advisor about your individual situation.
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