Why You Need Traditional and Roth Retirement Accounts

A combination of before and after tax retirement accounts allows you to hedge your bets against future tax increases.

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It’s a good idea to have some of your retirement assets in both before and after tax retirement accounts. We don’t know if taxes are going to be higher or lower when we retire. A combination of traditional and Roth retirement accounts allows you to diversify the way you are taxed.

[See 10 Costs That Could Increase in Retirement.]

You get a tax break in the year you make a contribution to a traditional IRA or 401(k), but income tax is due when you withdraw the money. With Roth IRAs or Roth 401(k)s you pay the tax up front and withdrawals in retirement are tax-free.

While the contribution limit is the same, post-tax accounts including Roth IRAs and Roth 401(k)s allow you to save more in tax-favored accounts because you pay the tax using funds outside the retirement account. For example, $15,000 in a Roth 401(k) is equivalent to $20,833 in a traditional 401(k) after a 28 percent tax rate is applied.

There are a several methods to adjust your retirement assets into a mixture of pre-tax and post-tax accounts. If most of your retirement assets are in pre-tax accounts, consider these ways to shift investments into Roth accounts.

[See 8 Ways to Fast Track Your Retirement.]

1) Roth 401(k) annual contributions. Employers are increasingly adding a Roth 401(k) option to their existing 401(k) plan. Consider shifting some or all of your annual contributions to a Roth 401(k) account.

2) Roth IRA annual contributions. Retirement savers within certain income limits can contribute up to $5,000 to a Roth IRA in 2010, which increases to $6,000 after age 50.

3) IRA conversions. You can convert some or all of your traditional IRA assets to a Roth IRA, but you will have to pay income tax on the amount you convert. If you do the rollover in 2010 you can spread the taxable income over two years.

4) Convert an old 401(k) to a Roth IRA. If you have a traditional 401(k) with a former employer you can roll it over to a Roth IRA.

5) Convert a traditional 401(k) to a Roth 401(k). A new law passed in September allows workers to convert traditional 401(k) assets to a Roth 401(k) in the same plan.

[Bookmark the U.S. News Retirement site for more planning ideas and advice.]

For about the last 10 years I have been making contributions to a Roth IRA account and a traditional 401(k) account. This has left me with roughly 18 percent of my retirement savings in post- tax retirement accounts and 82 percent in tax-deferred retirement assets. This year I’ve begun directing more of my 401(k) contributions to my Roth 401(k) to increase my post-tax retirement balance. I believe that shifting these contributions will provide me with the best tax allocation for retirement.

Brian Jaeger is the author of 2million's Personal Finance Blog. For the past 5 years Brian has chronicled his journey to reach his financial freedom goal of a $2 million net worth.