Farrell: Having traditional and Roth savings gives you tax-savvy options in retirement

I’m dismayed I hadn’t finished my income taxes by the time I wrote this column early the week of March 10 (though I’m hopeful by the time you read it the following weekend, I’ll be done).

Naturally, with the deadline looming April 15, I have taxes on my mind. And that led me to thinking about the benefits of building tax diversification with retirement savings.

Among the many uncertainties tied to retirement planning: We don’t know what our income will be during our elder years, especially if the timeframe is 10, 20 or 30 years from now. Compounding the uncertainty is not knowing how Congress might change the rules of the income tax system. That said, it’s a safe bet Congress will tinker with the tax code, adding and subtracting credits and deductions, modifying tax rates, imposing surcharges and so on.

These two uncertainties are why tax diversification is a smart strategy to include in retirement planning. Here’s the essence of the argument: With a traditional IRA, 401(k), 403(b) and similar tax-sheltered retirement plans, people make contributions with pre-tax dollars (within the legal limits and regulatory requirements among the different plans). You don’t pay taxes on your savings until you withdraw the money in retirement, and then you’ll pay your ordinary income tax rate on the withdrawals. Starting at age 73, you must start taking required minimum distributions (RMD) annually from these retirement plans (with some caveats).

In sharp contrast, with a Roth IRA, Roth 401(k), Roth 403(b) and comparable plans, your contributions are in after-tax dollars (again, within established limits and requirements). When you take out your earnings in retirement, the withdrawals are tax free. You also don’t have to worry about required minimum distributions with a Roth. (Designated Roth accounts in a 401(k) or 403(b) plan are subject to the RMD rules for 2022 and 2023. However, for 2024 and after, RMDs are no longer required from designated Roth accounts.)

If your income will be lower in retirement than when you were working, you’d favor traditional retirement savings. The Roth is the better choice if your income will be higher. Since you don’t know, the advantage of having some savings in each kind of account — traditional and Roth — is the flexibility to decide which account is best for withdrawals in any particular retirement year. (Taxable accounts also add to tax diversification, since you have better control of when to harvest tax losses and gains.)

Tax flexibility is valuable since life has a way of upending projections and plans.

Chris Farrell is senior economics contributor, “Marketplace”; commentator, Minnesota Public Radio.