Friday, April 25, 2008

Chances of being taxed on Roth IRA withdrawals; use tax diversification

The question to Walter Updegrave isn't phrased quite like the headline, but that's what I was thinking as I read the story. The questioner is actually worried that tax rates will fall, and that a pre-tax traditional IRA is a better bet than a post-tax Roth IRA. Updegrave's sage advice is:

But given how difficult it is to forecast future tax rates, I wouldn’t want to put all my money behind the assumption of higher or lower rates. Which is why I advocate “tax diversification.” The idea is that, come retirement time, you want some money in tax-deferred accounts that will be taxed at ordinary income rates. Some in Roth accounts that will be tax-free. And while you’re at it, I think it’s a good idea to have some investments in taxable accounts that are subject to the long-term capital gains tax rate.
I try to practice this advice. My reasons for this are a little different than one might think. I believe there is no way in heck that future tax rates are going to be lower. I don't put it past Congress to somehow tax Roth IRA withdrawals. Therefore, why not keep some money in traditional IRAs or 401(k)s, if you're going to get taxed anyways? Better to save some on the tax hit now. (Don't bring up that if Roth IRAs get taxed, traditional IRAs could just get taxed more, and I'd be in the same boat no matter once. I'll be the first to admit I have a weak argument here.)