As Tax Day approaches, many Americans will be making investment decisions for retirement. Conventional wisdom holds that young investors in lower income brackets benefit the most from investing in post-tax retirement vehicles such as Roth IRAs, while older, wealthier investors benefit from tax-deferred investment in accounts like traditional 401(k) plans and IRAs. New research from the University of Missouri reveals the best investment strategy for most individuals isn’t one or the other—it’s both.
Michael O’Doherty, associate professor of finance in the Trulaske College of Business, developed a model to determine the optimal retirement savings decisions of households with access to both pre-tax and post-tax accounts. The model accounted for age, current income and taxable income from outside sources in retirement.
“Our analysis emphasizes two aspects of the U.S. tax environment that are often ignored in retirement savings literature,” O’Doherty said. “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 pointed 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 and has ranged from 1 percent to 43 percent. As a result of this uncertainty, O’Doherty recommends that investors hedge their retirement bets by diversifying investments in both pre-tax and post-tax accounts.
“The most important thing is that people are saving for retirement,” he said, noting that recent research shows one in four American workers has less than $1,000 saved for retirement. “The best advice is to save as much as you can.”
How you save counts too, O’Doherty said. The exact “right” mix of investments depends on the individual, their age, income and tolerance for risk. Except for those investors in the lowest tax brackets, most individuals should split their retirement savings between traditional and post-tax investments, O’Doherty said.
“For retirement contributions, a good rule of thumb is to invest 20 percent plus your age into traditional, tax-deferred accounts,” he said. “Applying this rule, 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.”
According to the IRS, those interested in making a contribution to an IRA for the 2016 tax year can so do until April 18, 2017. The maximum contribution to both traditional and Roth IRAs for 2016 and 2017 is $5,500.
O’Doherty’s co-authors are David Brown and Scott Cederburg of the University of Arizona’s Eller College of Management. Their study, “Tax Uncertainty and Retirement Savings Diversification,” will appear in an upcoming issue of the Journal of Financial Economics.
Source: University of Missouri