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I'm contributing both to my 401(k) and a Roth IRA, so I will have both taxable and non-taxable funds for retirement. How is the tax rate figured when 401(k) withdrawals begin?
-- Tim, Plainfield, Illinois
I like the way you think, Tim. By participating in your company's 401(k) (which gives an immediate tax-deduction and then lets your investment gains build tax-deferred until retirement) and also contributing to a Roth IRA (which yields no tax deduction but allows you to pull out money tax-free), you are practicing what I like to call "tax diversification."
Let me explain.
Although I'm a big fan of 401(k)s, I also realize that they have a few inherent shortcomings. One is that you are at the mercy of where income tax rates are you begin pulling out your money. That's because withdrawals are taxed as ordinary income.
Let's say, for example, that you're in the 27 percent tax rate now. That means when you contribute $1,000, you get an immediate tax benefit worth $270. Plus, you're not paying any tax on interest or dividends -- another break at the 27 percent rate.
Even if you're still in the 27 percent tax rate in retirement, you come out ahead because your account value wasn't nicked by taxes each year -- that is, you were able to generate gains on money that would have otherwise been sitting in the government's coffers.
But what if Congress, in its inestimable wisdom, decides to raise tax rates, and you end up in, say, the 33 percent bracket at retirement? (Or, you get pushed into a higher bracket just because you've amassed so much money through diligent savings.)
In that case, you will have ended up deferring taxes at a low rate and paying them at a higher rate. Naturally, you'd prefer to the opposite.
The Roth balancing effect
If all your retirement money is in a 401(k), then all your money is subject to this possibility. But if you also have some money in a Roth IRA, then you've also got a pot of money that's immune to the tax rates prevailing during retirement.
With a Roth, you're paying taxes today for the promise of no taxes tomorrow. That bet pays off better for you if rates are higher in the future, since you will have paid taxes at a low rate and escaped them at a higher rate later on.
So when it comes to maximizing their tax benefits, 401(k)s and Roths are mirror images of each other.
With a Roth, you're better off if tax rates are lower during your career (because you're contributing after-tax dollars to the Roth) and higher in retirement when you're not paying them anyway.
If your tax rate is the same prior to and after retirement, then the benefits of a Roth and a 401(k) are the same, assuming you earn the same rate of return in both accounts.
There's no crystal ball for future tax rates
I suspect that many of us will drop into a lower tax bracket. But many will no longer have a mortgage deduction and other itemized deductions to lower our taxable income. So it's quite possible we could face a higher rate. And, of course, there's always the possibility that our legislators will boost tax rates.
Given that uncertainty, I think it's a good idea to fund both types of accounts -- to practice "tax diversification." This way, all your retirement money isn't subject to a single tax rate. Having a Roth as well as a 401(k) can also give you some financial flexibility in retirement.
If it appears that withdrawals from your 401(k) -- or from the Rollover IRA you've likely transferred your 401(k) into -- will push you into a higher tax bracket, you may be able to cut back those withdrawals by taking some money from your Roth instead. In years where you have plenty of deductions, you may find it better to draw more from your 401(k).
And don't forget that taxable accounts are also an element of tax diversification. If you have gains in stocks or mutual funds in taxable accounts that you've held for more than a year, you can sell them and pay taxes at capital gains rates, which, for now at least, max out at 20 percent, well below the top rates on ordinary income.
So I recommend that you continue your strategy of funding your 401(k) and a Roth IRA. Just be sure, of course, that you don't start contributing to your Roth until you've taken full advantage of the employer match in your 401(k).
I'm all for tax diversification, but I'm even more in favor of free money.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Mondays at 4:40 pm on CNNfn.