For many years, defined contribution plans, such as a 401k or 403b, have flourished based on the assumption that pre-tax savings would result in substantial tax benefits in retirement. The assumption in this case is that participants would make pre-tax contributions while working, reducing their income taxes in a period of presumably higher marginal tax rates. They would then pay income taxes on withdrawals of this money during retirement, presumably at lower tax rates.
What if income tax rates are higher during your retirement than they are now? Income tax rates have been relatively low in recent years; since 1980, the top marginal federal tax rate has fallen from 70% to a current 35%. Don’t be shocked if Congress increases tax rates – perhaps substantially – at some point in the future, in part because of the projected funding shortfalls for Medicare and Social Security.
The chance that you could be in a higher tax bracket during retirement is a good reason for “tax diversification” – owning both pre-tax (traditional IRA, 401k, 403b, etc.) and tax-free (Roth IRA, Roth 401k/403b) savings in aneffort to hedge against the risk of tax changes in retirement.
The recent introductions of the Roth 401k and 403b (effective January 1, 2006) provide an easy way for many American workers to choose between making contributions on a pre-tax or after-tax basis, or a combination of the two. Unfortunately, most employers have not yet adopted these plans for their employees.
As for the Roth IRA, recent tax law changes make it easier for many Americans to build up tax-free retirement savings. (See our follow-up article entitled “Tax Diversification Made Easier By New Tax Law”.) We can help you determine if you might benefit from these recent changes.
Your decision on whether to diversify your tax risk hinges on many factors and assumptions, too many to list here. Mentor Capital can advise you on this important issue as a part of our comprehensive financial planning process. If you would like to learn more about whether tax diversification would be good for you, give us a call.