NEW YORK — By now, the merits of asset and stock diversification in a retirement portfolio are well established, but what about tax diversification?
Just as financial advisers counsel clients to have a mix of different types of stocks in their portfolios in order to avoid putting too many eggs in one basket, many also suggest a move away from tax-deferred retirement savings as a way to hedge against an uncertain tax future.
With the Roth individual retirement account less than 10 years old, the bulk of most people’s retirement savings are parked in traditional IRAs or tax-deferred employer-based plans such as 401(k)s and 403(b)s. That leaves many open to hefty income tax bills long into retirement.
A heavier burden
The growing federal deficit and upcoming expenses are causing observers to conclude that future retirees will be footing much more in taxes down the road.
“If you find yourself like many baby boomers, you’ve probably got very little money that isn’t going to be subject to income tax when it’s withdrawn. Is that a smart move?” questioned Christine Fahlund, senior financial planner with T. Rowe Investment Services Inc. in Baltimore.
There now are more instruments in the adviser toolbox to spread around the tax risk. This year, the Roth 401(k) became permanent under the Pension Protection Act.
Previously, it was set to expire within five years, so employers and employees were wary of using it. Experts expect more companies to offer the accounts to their employees now that they are here to stay.
Like the traditional 401(k), the Roth version allows workers to set aside $15,500 a year ($5,000 more for those 50 and older). Workers can use a combination of the two as long as total contributions don’t exceed the cap.
Ms. Fahlund suggested that people saving for retirement direct all future contributions toward a Roth 401(k) if it is available, since most people already are heavily invested in the tax-deferred version. Some people may bristle at paying so much tax upfront.
Others might need the upfront tax deduction, Ms. Fahlund noted. But since it comes with no income cap, those who can afford to do so should, she added.
More importantly, favoring a Roth for years to come can remove a measure of doubt from retirement planning.
“A Roth takes all the uncertainty out of future taxes, because future taxes on a Roth are zero,” said Ed Slott, a financial planner and certified public accountant in Rockville Centre, N.Y., and the editor of the newsletter Ed Slott’s IRA Advisor.
To his way of thinking, a worker is better off prepaying taxes at what he said are unbelievably low tax rates. The argument is even more compelling for younger workers just starting out.
“People always say that they could end up in a lower tax bracket in retirement, but in my experience, that never seems to happen,” Mr. Slott said. “If you have substantial retirement accounts, and you have to take the
required minimum distribution, then it will increase income; you’ll pay taxes on
Social Security, too.”
What’s more, becoming widowed often bumps people into a higher tax bracket, because their same annual income now is counted for a single person, according to Gregory B. Gagne, founder of Affinity Investment Group LLC of Exeter, N.H. And becoming widowed during retirement isn’t uncommon.
“I call that the widow tax trap,” Mr. Gagne said.
Having sources of tax-free income to tap during retirement can alleviate that tax burden, he said. “With tax-deferred assets, you’re just postponing the inevitable taxes.”
A betting man or woman might look at today’s extremely low income tax rates — 35% at the highest marginal rate — and conclude that there is nowhere for taxes to go but up. Aside from the fiscal health of the government, the rates are set to expire in 2011.
Regardless of which party wins the presidential election in 2008, future administrations will likely feel the squeeze of rising expenses.
The wars in Iraq and Afghanistan, mounting Medicare costs and calls for universal health care are putting strains on the government’s ability to keep taxes as low as they are today — just as the leading edge of America’s 77 million-strong baby boomer generation approaches retirement age.
“If taxes were a stock, I’d buy up all I can, because they’re only going to go up,” Mr. Slott said.
There will be another opportunity for savers to diversify into Roths. In 2010, the income cap for conversion of a traditional IRA to a Roth will be removed.
Today, only those with modified adjusted gross incomes of less than $100,000 are eligible to perform the conversion. Taxes on the conversion, which will be based on all IRA accounts, not just the one being converted, won’t be due until the following year and can be spread out to two years.
“That’s when the floodgates will open,” Mr. Slott said.
Ms. Fahlund suggested that affluent individuals bring as much money into ordinary IRAs now as possible, even if it means contributing to a non-deductible version. The opportunity to diversify away from tax-deferred savings may not come again.
“If you can change the [tax] character of that money, you might want to jump on it, Ms. Fahlund said.
Favors diversification
Of course, some planners aren’t willing to make wagers one way or another.
“Because we don’t know what tax rates will be in the future, I think it’s a good idea to have different pots of money to draw from,” said Timothy Wyman, a partner with the Center for Financial Planning Inc. in Southfield, Mich., which has $650 million under management.
He prefers that his clients divide their retirement assets among Roth, tax-deferred and taxable accounts in order to stay nimble on the tax front. Since each account is taxed differently, the three can provide maximum flexibility.
For example, it might make sense for a retiree to make a big-ticket purchase out of a taxable account in order to allow a Roth to continue growing tax free or to avoid the income taxes that would be owed by using money from a regular IRA.
Mr. Wyman worries that in an effort to avoid income tax during retirement, savers will forgo the potential employer match and other benefits of the 401(k), the workhorse of American retirement.
“There are no proposed bills talking about increasing taxes at this point, so I wouldn’t want to make a lot of changes to clients’ portfolios,” he said.
