The sweeping tax reforms that lowered rates for businesses and individuals while eliminating many popular deductions did not change the equation for retirement asset location, according to the authors of key research about retirement saving.
The best solution for a successful, tax-aware retirement savings strategy is to balance and diversify between tax-deferred accounts and Roth accounts, according to “Tax Uncertainty and Retirement Savings Diversification,” a 2016 study by University of Arizona professors David C. Brown and Scott Cederburg, and University of Missouri professor Michael S. O’Doherty.
“I think the tax reform really affirms the research that tax uncertainty is a huge issue for retirement savings,” Brown said in an interview with Financial Advisor. “Since they decided not to significantly change contribution limits, a diversification strategy makes a lot of sense.”
Though Congress considered proposals to lower the 401(k) contribution limits for couples and individuals in traditional accounts, or to “Roth-ify” workplace retirement plans by removing entirely participants’ ability to defer taxes, the final version of tax reform left retirement plans relatively untouched.
Over the 105 years since the introduction of the income tax, the marginal tax rate for a single filer with an adjusted gross income of $100,000 has fluctuated between 1 percent and 43 percent, changing approximately 40 times. Even after last year’s tax reform package, the future trajectory of tax rates remains in doubt, which means the report’s findings still generally hold true.
“This reform really introduces more uncertainty as to the future of tax rates,” said Brown. “They’ve introduced a bigger deficit, and eventually they’re going to have to cover that deficit. What will taxes look like if there’s a shift back towards Democrats over the next election cycle? There might be a cycle of tax reforms every four to eight years.”
In 2016, Brown, Cederburg and O’Doherty found that by balancing between Roth and traditional retirement accounts, retirement savers of all ages and wealth levels could better hedge against tax uncertainty.
The researchers discovered that portfolio returns could be enhanced by 1 to 2 percent annually by balancing between a Roth account and a traditional account.
One potential rule of thumb for savers and advisors alike would be to invest a proportion of assets equal to 20 percent plus the account-holder’s age into traditional retirement accounts, with the remainder in Roth accounts. Thus, 40-year-old clients would put 60 percent of their retirement assets into a traditional 401(k) or IRA, and 40 percent into a Roth account, while 60-year-old clients would put 80 percent of their assets into traditional accounts and just 20 percent into a Roth account.
Clients who will enjoy lower tax rates due to the law may find saving in Roth accounts more attractive, said O’Doherty.