Everyone knows the value of diversification.  Just look at the Bear Stearns incident for proof that it’s crucial.  I’m not going to talk about that today for a change.  Rather, I’m going to focus on diversification of your actual accounts - not within them.  What in the world am I talking about?  Taxes.

Roth IRA vs 401(k)

The debate between which of these two great retirement accounts is better has been going on as long as they have both been around.  My thinking is that one is not better than the other.  Individually, each is worse than they would be together.  Bear with me for a moment, before you call me crazy.  I am going somewhere.  Let’s try it this way - with numbers. 

I’m going to take one initial $5,000 investment and show you how powerful a combination of accounts can be.   In this example, you are currently in the 25% tax bracket, and you end up in the same bracket when you retire.

As you can see, both the Roth IRA and 401(k) end up with the same value at the end.  They always equal each other if your tax bracket remains the same.  But look over at the combo accounts - the ending value is more than $4,000 higher.  What happened, you ask?  Well, let’s see.  The Roth income is not taxed when you withdraw it, and it does not count as income.  The 401(k) is your only taxable income.  In the government’s eyes, your income is lower, so they toss you in a lower tax bracket - 15% in this example.  You have the same pre-tax money, of course -it’s just that you pay less taxes. 

My retirement advice remains that you should always contribute enough to your 401(k) to get the maximum match.  That’s free money, and no tax savings is going to make up for missing out on it.  But once you’ve hit that point, you need to open a Roth IRA and fund it as much as you can.  Your goal, if your income provides, should be for a rough 50/50 split between the two accounts.  That will put you in the best situation from a tax standpoint.  Paying less taxes means that you end up with more money in your pocket.  That’s good news anytime - but in retirement, it’s even more important.

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