How to hedge against risk of taxes in retirement

Personal Finance

March 11, 2007|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

A lot of retirement planning today is based on tax avoidance.

Take the popular 401(k). You put pretax money in the account now and pay Uncle Sam his due later when you use the cash in retirement.

But if all your retirement income sits in tax-deferred accounts, you're vulnerable to whatever the tax rates on ordinary income will be in the future. And they could be a lot higher.

For that reason, you might be better off paying some taxes now. Spreading retirement dollars across a mix of accounts that are taxed in different ways will give you more flexibility to manage your tax bill later.

Call it tax diversification.

"To me, tax diversification is trying to hedge against future tax risk," says Joel Dickson, a principal with the Vanguard Group in Malvern, Pa.

Taxes, of course, shouldn't drive investment decisions. And there's no guarantee where rates will be in the next 10, 20 or so years. But many experts think there's only one way they can go. Today's exceptionally low rates are set to expire in 2011 and the federal government is operating in the red.

If the income tax rate were a stock, "I would buy all that I could buy ... because I know it's going up," says Ed Slott, an accountant in Rockville Centre, N.Y.

This is not to suggest workers abandon the 401(k). Indeed, if you aren't saving enough for retirement - and surveys indicate that's a huge number of Americans - you need to be socking away as much as you can in your employer's plan.

But if you're an avid saver and can afford to pay some taxes now in exchange for tax breaks later, don't overlook tax diversification. These days it's even easier to be diversified with the introduction of the Roth IRA, and, more recently, the Roth 401(k). And Congress has made it possible for even more people to be eligible for the tax-friendly Roth IRA in the future.

There are no hard-and-fast rules for tax diversification.

Linthicum financial planner John Bacci says he tells clients to think of it as putting retirement money in three buckets.

The first and most crucial is the 401(k). Workers' first step is to make sure they contribute at least enough to get any employer match, Bacci says.

The second bucket is a Roth IRA, where you pay taxes on the money before it goes into the account, but withdrawals are tax-free in retirement. Unlike traditional IRAs and 401(k)s, the Roth has no mandatory distributions after age 70 1/2 . Savers this year can set aside up to $4,000 in a Roth, plus an extra $1,000 if they are 50 or older.

Not everyone today is eligible, though. Full or partial contributions to a Roth can be made this year if adjusted gross income is less than $114,000 for singles and $166,000 for joint filers.

The third bucket, if you have money left over, is taxable accounts. In this bucket, Bacci says, small investors should consider tax-efficient investments such as exchange-traded funds or index funds that will largely be subject to capital gains tax. The top tax rate on long-term capital gains is now 15 percent.

As a guideline, Bacci recommends investors keep at least 60 percent of their retirement assets in the 401(k), about 20 percent in the Roth and the rest in a taxable account. This way, he says, retirees have three buckets to draw upon depending on what works best for them.

"All diversification gives you in this case is options," Bacci says. "You have three buckets and the only thing you know for sure is those buckets will be taxed differently by the government. And I'm not going to put all my eggs in one bucket."

Rania V. Sedhom, a senior manager with BDO Seidman in New York, says she recommends clients take advantage of a Roth 401(k) if an employer offers one.

The Roth 401(k) became available last year, but many employers hesitated to adopt the plan because it was set to expire after five years. Congress has since made the Roth 401(k) permanent, and companies have been adding the account along with a regular 401(k).

The Roth 401(k) combines features of the 401(k) and the Roth IRA.

Worker contributions go into the Roth 401(k) after taxes have been paid on the money, but the distributions in retirement are tax free. Employer matches, though, will be subject to regular income tax.

Contribution limits are the same as with a regular 401(k), which this year is a maximum of $15,500 for younger workers and an extra $5,000 for those 50 and older.

Sedhom says a worker can easily achieve tax diversification by splitting contributions between the regular 401(k) and the Roth 401(k). Combined contributions can't exceed the annual limit, though. In other words, you can't put away $15,500 in each.

Some workers have been shut out of the Roth IRA because of their higher incomes. Congress made a change last year that will give high-income workers backdoor access to a Roth IRA beginning in 2010.

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