A new study says that older workers saving for retirement might be well advised, contrary to popular wisom, to use both Roth IRAs and traditional retirement plans to put their money away.
Older workers have usually been cautioned away from Roth IRAs, for more than one reason — not only are they generally looking for the tax break that a traditional plan brings to the table, but higher earnings can make them ineligible to use Roths.
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But, according to a study from the University of Arizona Eller College of Management, the protection against tax uncertainty provided by Roths can offer an additional layer of protection against risk to retirement assets.
The study, titled "Tax Uncertainty and Retirement Savings Diversification," co-authored by UA Eller College finance professors Scott Cederburg and David C. Brown and University of Missouri finance professor Michael S. O'Doherty, considered not only return uncertainty but also the risk of changing tax rates.
To do this, they developed software to account for tax uncertainty when analyzing investors' contributions between pretax traditional and post-tax Roth versions of tax-advantaged retirement accounts. While traditional accounts can mitigate the risk of investments' performance, since poor performance and lower account balances will result in a lower tax bill when withdrawals are made, Roths instead protect against the uncertainty of tax rates by compelling savers to pay taxes up front. And that's something not generally considered.
The study pointed out that historically, taxpayers have faced considerable uncertainty regarding future tax rates. Since 1913, married taxpayers with an inflation-adjusted income of $100,000 have seen the marginal tax rate change 39 times, ranging from 1 to 43 percent. The software analyzed the relative benefits of the two types of accounts while factoring in the potential for changing tax rates.
While each type of account provides protection against risk, the Roth's ability to limit the negative impacts of tax rate uncertainty were accounted for. Traditional advice for higher-income investors to stick to traditional retirement accounts "doesn't consider the risk of tax rates increasing," Cederburg said in a statement.
Employers who provide employees with access to Roth 401(k) accounts give them the ability to manage their tax-rate risk. Brown said in a statement that accounting for tax-rate risk improves investors' retirement prospects, "effectively saving them the equivalent of mutual fund management fees."
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