Make a strong retirement plan even stronger
If your employer offers a Roth 401(k), it may be advantageous to sign up for one simple reason: tax diversification.
NEW YORK (Money) -- QUESTION: My employer now offers a Roth 401(k) option and I want to know if I should shift some, or all, of my monthly contributions from my regular 401(k) to the Roth.
My husband and I are both 52 and we typically earn $140,000 a year or more, combined. We max out our 401(k) plans each year (my husband gets a 3% match; I get none) and we save another $10,000 or more a year in taxable accounts.
We've got about $255,000 in our 401(k)s, $275,000 in various taxable accounts, $345,000 in investment real estate and $200,000 in home equity.
I'm hoping to retire at 60, but hold off drawing Social Security until age 66. What do you think? - Connie, Raleigh, North Carolina
RESPONSE: First of all, Roth 401(k) or no, I've got to hand it to you and your husband for the splendid job you're already doing in building yourselves a nice little nest egg for retirement. You've put away some decent money and continue to salt away even more bucks. You've got your stash spread among a variety of different asset classes. And, most important, you appear to be putting real thought into how you go about your retirement planning.
Based on what you've outlined above however, it sounds to me as if you and your husband may be able to improve your retirement prospects even more if you do the Roth 401(k).
Tax diversification Why? To begin with, by adding a Roth to your retirement repertoire you will be able to reap the benefits of what I like to call "tax diversification."
The money in your regular 401(k) plans will be taxed in retirement at ordinary income rates. You've also got money that will likely be taxed at long-term capital gains rates.
The taxation of your real estate investments is more complicated, but basically it boils down to a combination of ordinary income and long-term capital gains.
What you're missing, though, is a pool of tax-free assets. That is an account you can easily pull money from without having to give some back to the tax man. (Yes, up to $500,000 in gains in your home escapes taxes, but this isn't a particularly easy asset to get at and certainly not one you want to be tapping early in retirement.)
By having buckets of money that receive different tax treatment, you gain a lot more maneuvering room in retirement.
For example, if it appears that additional withdrawals from your 401(k) in a given year might push you into a higher tax bracket, you could instead tap your Roth for tax-free cash.
Or you could sell appreciated assets in your taxable accounts that you've held longer than a year and pay tax at the long-term capital gains rate, which now maxes out at 15 percent for securities like stocks, bonds and mutual funds. For that matter, you might even be able to sell some assets for a loss in your taxable accounts and use that loss to offset other investment gains or even ordinary income.
Most important, though, diversifying your potential tax liability assures that all your stash isn't vulnerable to just one tax rate. For example, if most of your savings are in 401(k)s and IRAs and you move into a higher tax bracket for ordinary income (or Congress raises ordinary income rates), your nest egg has effectively shrunk.
Just as spreading your money among different types of assets provides protection from uncertainty, so too does diversifying your tax exposure. (For more on the benefits of tax diversification, click here.)
Money money tax free But even aside from the diversification benefit, there are other good reasons to do a Roth. For example, as long as you stay in the same tax bracket or a higher one after you retire, funding a Roth to the max (whether it's Roth 401(k) or Roth IRA) allows more of your money to grow without the drag of taxes. That makes it a better deal than a traditional 401(k) or IRA. (For details on why this is the case, check out my Long View column in the August issue of MONEY.
Of course, it's possible that you'll drop into a lower tax bracket in retirement, in which case the Roth isn't as good a deal (because you'll have paid taxes on your Roth contribution when you faced a higher rate and avoided taxes when you faced a lower rate - exactly the opposite of what you'd like to do).
But you would still have your regular 401(k) assets, which would be more attractive at the lower rate. And besides, even if the Roth doesn't turn out to be the best deal from a tax standpoint, I think there's big psychological and emotional benefit in retirement to knowing you've got an account that represents actual spending power, money you can withdraw without having to worry about the IRS taking a cut.
So my advice is yes, go ahead and fund that Roth 401(k) and do it to the max if you can. Come retirement time, I think you and your husband will be glad to have the flexibility and additional sense of security that having a truly diversified retirement portfolio can provide.