Retirement savings: Don't overdo it with the Roths

(MONEY Magazine) -- Question: I participate in a Roth 401(k) plan that also offers company matching funds. My question: Assuming our income isn't too high, can my wife and I also fund Roth IRA accounts? -- Mike Butler, Lindenhurst, Ill.

Answer: The short answer is yes.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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As long as you meet the income eligibility rules, you can contribute to a Roth IRA regardless of whether you also participate in your company's Roth 401(k) plan.

That's also true, by the way, if you participate in a regular 401(k) as opposed to the Roth version.

So as long as your combined modified adjusted gross income (or MAGI, as they say in tax circles) is less than $167,000, both you and your wife can contribute up to $5,000 to a Roth IRA this year, plus an extra $1,000 if you're 50 or older. In fact, even if your MAGI equals or exceeds $167,000, you can each make a partial contribution as long as it's less than $177,000.

But while I applaud your desire to augment your 401(k) savings by also doing an IRA, you want to be sure you're not overdoing it with Roths.

As I've noted before, you're generally better off in a Roth 401(k) if you expect your tax rate in retirement to be higher than when you made your 401(k) contribution. Conversely, if you think you'll be in a lower tax bracket in retirement, a traditional 401(k) is generally a better deal than a Roth. The same goes for a Roth IRA vs. a traditional deductible IRA.

The problem is that it's difficult to know what tax rate you'll confront in retirement. That will depend on a variety of factors, including the amount of money you draw from different types of investment accounts; whether you work periodically after retiring; the size of various deductions and exemptions you may have; and, of course, whether Congress toys with tax rates in the future. Your tax bracket in retirement could even vary from year to year as your income needs change.

Given that inherent uncertainty, I say it's a good idea to hedge your bets by practicing what I like to call "tax diversification." Essentially, that means spreading your retirement savings among different types of accounts that receive different tax treatment.

So, for example, you would want to have some of your money in traditional 401(k) and/or IRA accounts whose distributions are taxed at ordinary income rates at withdrawal and another portion of your savings in Roth 401(k) and/or Roth IRA accounts that allow for tax-free withdrawals in retirement. Ideally, you would even want to have some dough in taxable accounts in investments such as index funds, tax-managed funds and growth stocks that generate most of their return through unrealized capital gains that are eventually taxed at the more favorable long-term capital gains tax rate.

By diversifying your tax savings this way, you're avoiding putting all of your savings eggs in one tax basket, so to speak. This approach also gives you some flexibility in determining your annual tax bill in retirement.

For example, if your income needs are modest in a given year or you have sizeable deductions that will lower your taxable income, you may want to get most of your income from a tax-deferred account like a traditional IRA to take advantage of the fact that you're in a low tax bracket that year. If, on the other hand, it appears that draws from tax-deferred accounts will push you into a higher tax bracket in a particular year, you can avoid that by tapping Roth accounts for tax-free income.

Getting back to your situation, you don't say how much money you have in non-Roth accounts. I assume you have at least a small amount of tax-deferred retirement savings, however, since employer matching funds must go into a regular 401(k) account, even if you contribute to a Roth 401(k). But you may also have additional tax-deferred savings from 401(k)s at previous jobs or in traditional IRA accounts you have already funded.

Whatever the case, you and your wife should think about how you want to divvy up your retirement savings between tax-deferred accounts (traditional 401(k)s and IRAs) and tax-free accounts (Roth 401(k)s and IRAs). As I explained in a previous column, I don't think it's possible to arrive at an "ideal" mix. But the more likely you think you'll end up in a higher tax bracket in retirement, the more you'll want to favor Roth accounts.

And the more apt you think you are to fall into a lower tax bracket after retiring, then the more you'll want to tilt your savings effort toward non-Roth accounts. It's doubtful, though, that you would want all or virtually your savings in just one type of account.

All of which is to say that if you've got nearly all your retirement savings wrapped up in that Roth 401(k), you may want to at least consider funneling more savings into a tax-deferred account, which you may be able to do by contributing more pre-tax dollars to your 401(k) (an option all employers offering Roth 401(k)s must offer) or by funding a traditional deductible IRA rather than a Roth IRA, assuming you qualify.

So by all means boost your overall savings effort by contributing to an IRA in addition to your Roth 401(k). But don't automatically assume that a Roth IRA is the best way to go just because the tax laws allow you to fund one.