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To Defer or Not To Defer—How About Both?

Investors hedge their retirement bets by diversifying investments in both pre-tax and post-tax accounts.

One of the major questions that every retirement planner has to answer is whether or not to defer taxes on retirement savings. Often this dilemma boils down to a choice between pre-tax accounts like traditional IRAs and 401(k)s — which conventional wisdom holds most benefit younger, lower income investors — and post-tax options, namely Roth IRAs which supposedly are better for older, wealthier clients.

New research from the University of Missouri reveals the best investment strategy for most individuals isn’t one or the other — it’s both.

Armed with the knowledge that, historically, tax rates have vacillated wildly — meaning that what seems prudent for a client today may not necessarily be the case when he actually retires — Michael O’Doherty, associate professor of finance, developed a model accounting for age, current income and income from outside sources in retirement to determine the optimal retirement savings decisions of households with access to both pre-tax and post-tax accounts.

“Our analysis emphasizes two aspects of the U.S. tax environment that are often ignored in retirement savings literature,” O’Doherty explains. “First, the tax system is progressive, meaning that the level at which you are taxed varies widely depending on income. Second, future tax policies are unknown.”

For example, O’Doherty points out that the tax rate for married taxpayers with inflation-adjusted income of $100,000 has changed 39 times since the introduction of income taxes in 1913 — running the gamut from 1 percent to 43 percent. 

“If you look at the conventional advice that’s given, there doesn’t seem to be much acknowledgment of this idea of tax uncertainty,” he notes. “That advice is often based on this idea of ‘compare your income today to your expected income in retirement,’ and our thought was that all of that advice is sort of assuming that the tax environment in 30 years will look the same as today.”

As a result of this uncertainty, he recommends that investors hedge their retirement bets by diversifying investments in both pre-tax and post-tax accounts.

“For retirement contributions, a good rule of thumb is to invest 20 percent plus your age into traditional, tax-deferred accounts,” he said. For example, “a single 40-year-old investor with at least $40,000 of taxable income would put 60 percent of their retirement contributions in a traditional IRA or 401(k)-type plan.”

The effects of tax uncertainty are most pronounced as wealth level increases. “On the high end of the spectrum, conventional advice tells you that traditional accounts make the most sense,” O’Doherty explains. “But we found that those investors actually have a ton of exposure to tax uncertainty. The higher brackets and marginal rates tend to have more volatility and uncertainty based on the historical record.” So, according to the paper, getting as much Roth exposure as possible is key to hedge against this increased uncertainty.

For most advisors, these concepts will not be new. But applying them in this way may be. “The traditional mantra in finance is investment diversification and this is applying that same sort of concept to tax risks in retirement.”

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