Kent Thune for About.com writes: The question over which type of retirement savings account to use for the best tax benefit is somewhat of a guessing game. I recently responded to a reader email asking that question. Here is an extended version of my answer to the reader:
In general, if you expect to be in a higher federal tax bracket in retirement, the Roth IRA is best. If you expect to be in a lower tax bracket, which is most common, the traditional IRA is best. If you will be in the same tax bracket, it doesn't matter which one you use. You may also consider using a regular brokerage account as an alternative. You may also use a combination of all three and don't forget about your 401(k)! Above all, knowing what federal tax bracket you will be in at the beginning of retirement will be your biggest challenge.
Should You Use a Regular Brokerage Account for Retirement Savings?
A regular brokerage account is not tax-advantaged. However you only pay taxes on dividends (interest earned) each calendar year and you only pay taxes on the gains (capital gains tax) upon withdrawal. Typically, capital gains taxes are lower than federal income taxes. For example, the capital gains tax rate is currently 15%. By comparison you will pay federal income tax on 100% of the withdrawals from a traditional IRA. So if you withdraw $40,000 from your traditional IRA in the first year of retirement and your federal tax rate is 25%, you will pay $10,000 in federal taxes. Whereas if you withdraw that same amount from a regular brokerage account, and assume that $20,000 of your $40,000 represents gains, you will pay $3,000 in capital gains (20,000 x .15).
Trying to Win the Taxation Guessing Game
The guessing game is that no one knows with certainty what tax rates will do over the next 10, 20 or 30 years. From a historical perspective, the US federal tax rates are relatively low now. This may lead one to the reasonable expectation that rates will likely go higher in the coming decades. Furthermore the federal government has dramatically increased its debt over the past 10 years or so and this debt is a taxpayers' burden. Logically speaking, higher debt expenses in the future must be paid by higher revenues (tax). The best guess is for higher income tax rates in retirement for those who have 10 years or more until they begin withdrawing from retirement accounts.
Tax Diversification and Asset Location
However, assuming federal tax rates will increase and your income needs will decrease, it is possible that you may be in the same income tax bracket in retirement as you are now. It's a kind of "one step up and one step down" effect. You may move to a higher tax bracket between now and retirement but then step back down upon entering retirement (presumably due to lower income needs).
I believe the conventional wisdom put forth by most financial planners with regard to retirement savings is generally wise: If your employer offers a 401(k) with a match, contribute enough to receive the match. Any additional savings should go to a Roth IRA. If you are able to save beyond the max for your Roth IRA, which is $5,500 in 2013 ($6,500 for age 50 and over), you can put additional savings in an individual brokerage account.
The final step in tax planning for retirement is to know which account should hold certain investments. Read my article on asset location for more tips on tax planning with regard to knowing which investments work best (or worst) in certain accounts based upon tax efficiency. I also recommend reading the Top 10 Things to Know About Mutual Fund Taxation.
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