Tax uncertainty and retirement savings diversification

Abstract

We investigate the optimal savings decisions for investors with access to pre-tax (traditional) and post-tax (Roth) versions of tax-advantaged retirement accounts. The model features a progressive tax schedule and uncertainty over future tax rates. Traditional accounts are valuable for hedging retirement account performance and managing current income near tax-bracket cutoffs, whereas Roth accounts allow investors to mitigate uncertainty over future tax schedules. The optimal asset location policy for most households involves diversifying between traditional and Roth vehicles. Contrary to conventional advice, the substantial economic benefits from Roth investments are not limited to investors with low current income.