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By timestaff
April 24, 2008

No one can predict what the future holds, so you might be better off hedging your retirement by tax diversifying.

Question: I'm 33 and have invested in a Roth IRA for 13 years. This is my only retirement account as I don't have access to a 401(k). With all the talk of a flat tax and other tax reforms, it seems possible that by the time I retire the income tax could be less of a hit than it is currently. So do you think it would make sense for me to split my IRA contributions between traditional and Roth IRAs? —Michael, Portland, Oregon

Answer: Let me start by saying that I have no special insights into what type of income tax regime a future administration might propose and that Congress might enact.

I suspect that given how entrenched the current tax system is and how many different interest groups have a stake in keeping the status quo that the chances for a radical overhaul are slim. And given the looming shortfalls in programs like Social Security and Medicare, I would also expect that if we do stick with the current system that tax rates would more likely rise than fall in the future.

But I freely admit that I could be underestimating the will for changing a system that is far too complicated, subject to all sorts of manipulation and, perhaps worst of all, wastes an astounding amount of resources when you consider all the time and energy spent by people either trying to comply or evade its provisions.

So for all I know, maybe we could eventually end up with a flat tax with a lower rate than many people pay today but with fewer deductions. Or perhaps we'll get the "fair tax" system that taxes consumption. Or maybe Congress will pass a "Just send us your paycheck, we’ll take what we need and send you back the rest" tax. (Okay, I made that last one up.)

But even if some crystal ball could tell you what sort of system we'll have in the future, I doubt that it would also be able to foretell all the details that will eventually determine the rate you'll pay - what sorts of exemptions and exclusions might apply or what length of transition period we might have.

So what does all this mean for your situation?

Well, as I've noted before, although there are some additional wrinkles involved in deciding between a regular IRA and a Roth (or a regular 401(k) and a Roth, for that matter), you’re generally better off doing a Roth if you expect to be in the same or higher tax bracket when you withdraw your money, while the regular IRA is generally the better deal if you expect to be in a lower tax bracket at withdrawal compared to when you put your money in.

But given how difficult it is to forecast future tax rates, I wouldn't want to put all my money behind the assumption of higher or lower rates. Which is why I advocate "tax diversification." The idea is that, come retirement time, you want some money in tax-deferred accounts that will be taxed at ordinary income rates. Some in Roth accounts that will be tax-free. And while you're at it, I think it’s a good idea to have some investments in taxable accounts that are subject to the long-term capital gains tax rate.

I'm not saying this strategy is foolproof. I don’t for a minute underestimate Congress's inventiveness when it comes to ways of squeezing more revenue out of us. But you can’t cover every contingency, and I believe the approach above is a reasonable one given your options. All of which is to say that I think your instinct to hedge your bets by having money in both a Roth and a traditional IRA is a good one.

There are any number of ways you might pull off this strategy, and I've laid out one method in a previous column. In the case of a person like you who is young and presumably has decent prospects for a rising income, I'd probably be more inclined to stick to the Roth for now on the theory that you still have plenty of time to build tax-deferred accounts. You can always fund a regular IRA later if you’re in a higher tax bracket. Or you may have an opportunity to fund a tax-deferred 401(k) later on if you switch jobs.

But if you're anxious about having your entire retirement stash in a Roth and would like to start this process of diversifying your tax exposure sooner, I think that's a perfectly reasonable decision as well. Essentially, it's a judgment call.

Ultimately, you have no control as an individual over what tax system or tax rates you'll face in the future. But you do have control over how much you save.

So whatever you do, make sure that you continue to fund some sort of IRA to the max every year. Otherwise, your nest egg may not be large enough to support you in retirement whatever your tax rate turns out be.