A New Approach to Retirement Savings

Mitigating Tax Risk with a Mix of Savings Plans

Scott Cederburg and David Brown

When it comes to investing for retirement, financial advisors have long looked to a general principle: People who make less should invest in Roth retirement vehicles, and others should stick to traditional IRAs and 401(k) plans. It’s not a hard and fast rule, and other factors come into play, but the basic reasoning is simple and based on a key difference between the two types of plans. Roth investments are taxed now and never later – the opposite of traditional plans. Thus, low-earners benefit from paying taxes now, but the traditional plans win out for everyone else. 

That decades-old conventional wisdom, however, came up short in a recent study co-authored by Eller Associate Finance Professor Scott Cederburg and Assistant Finance Professor David Brown. Recently published in the Journal of Financial Economics,the research showed that the optimal everyday strategy is more nuanced. 

Cederburg, Brown and a third collaborator approached the question of investment from an angle of risk largely overlooked: the uncertainty of future tax rates. If we knew that our income tax rate in retirement would be the same or lower than it is today, then investing solely in traditional plans would make sense. Conversely, a guaranteed higher future tax rate would advantage paying taxes now, as one does in a Roth account, for which future sums are forever tax-free. 

Can we reasonably predict which scenario we’ll face? Probably not, given the volatility of the U.S. tax code. As an example, the researchers point to the tax rate for a married couple making (adjusting for inflation) $100,000 a year. It’s ranged from 1 percent to 43 percent since 1913, changing 39 times. 

In the face of that unpredictability, the study found that optimal savings result from splitting investments between the two types of plans, effectively hedging our bets. Using a mix of Roth and traditional accounts, investors can expect to improve their effective performance by as much as one percent per year.

And what is that mix? The exact equation depends on age, income and wealth, but it can be boiled down to a simple guideline that produces near ideal results: Add 20 to your age – that’s the percentage of savings to put into traditional plans, and the rest goes into a Roth account. If you’re 30 years old, that means a 50/50 split. If you’re 50, it’s a 70/30 split. 

Of course, that diversification doesn’t totally mitigate tax-based risk. And people in the lowest income brackets will still benefit from Roth-only investment. The most important thing, Brown says, is to “avoid investing entirely in traditional accounts or entirely in Roth accounts – a blend between the two is almost certainly better.”