It turned out it was just some year-end distributions. You probably heard or read about the usual advice “don’t buy a fund distribution” or more generically “don’t buy a dividend.” So how do fund distributions affect investors? What exactly is so bad about buying a distribution?

Let me explain with this real life example in my account. I bought only a few days before the fund made the year-end distributions. The day before the distributions, I had 262.123 shares at $7.76 per share worth $2,034.07. I received $547.66 in capital gains distribution. After the distributions were reinvested, I had 356.222 shares at $5.82 per share worth $2,073.21. More shares at a lower price. My account value actually increased. Because my fund is held in an IRA, there is no tax implication anyway.

Reminder #1: If you are investing in a tax deferred account, don’t worry about buying a fund distribution.

If you only invest in tax deferred accounts (401k, 403b, 457, traditional IRA, Roth IRA, etc.), buying a year-end distribution is not a problem.

What if it’s a taxable account? In my example, I would have to pay tax on the $547.66 distributions even if I reinvested them into the same fund. But my cost basis also would increase by the same amount. When I eventually sell the fund, I will have a smaller capital gain at that time. Therefore,

Reminder #2: Taxes paid on capital gains distributions now will be at least partially offset by lower taxes in the future.

What if I invested in a taxable account and I took the usual advice of waiting until the distributions are done? I paid $2,000 for my shares on Dec. 5. Had I known that the fund will have a large distribution in a few days and I decided to wait until Dec. 10 to make my purchase, to acquire the same number of shares I now have, I would’ve had to pay $2,073.21 on Dec. 10 whereas I only paid $2,000 on Dec. 5. The extra $73.21 due to price changes would take a big chunk out of the tax savings from avoiding the distributions while I would still have a higher capital gain and higher taxes in the future. Waiting until year-end distributions are done is not necessarily the best in all cases.

Reminder #3: Price movement can trump tax savings.

If the distribution is small, it may not be worth avoiding.

So why do they say “don’t buy a fund distribution”? Because if you do, in a taxable account, you pay more taxes now and less taxes in the future. That’s the mirror image of deferring taxes. You accelerate the taxes from the future years into the current year. You can also turn a long term capital gain in the future into a short-term gain in the current year. Short-term gains are taxed at higher rates than long-term gains.

What do you do if you invest in funds that tend to make large distributions? Such funds are said to be “less tax efficient.” First, ignore the issue if you are investing in a tax deferred account. Tax efficiency simply doesn’t affect you in 401k, 403b, IRA or Roth IRA. Second, consider if you should invest in the less tax efficient funds at all. More tax efficient funds may perform just as well after you take taxes into consideration. Third, if that’s your only choice, consider trading places with some more tax efficient funds in a tax deferred account. Move the less tax efficient fund into a tax deferred account and move some more tax efficient funds to the taxable account. Finally, harvest tax losses when you can so you have a reserve of tax losses which can be used to offset the capital gains distributions.

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This question of whether one is better off with contributing to the Traditional 401k or contributing to the Roth 401k has been the subject of a lot of debate. Although there is no one-size-fits-all answer, I think for most people the majority, if not 100%, of the contribution should go to a Traditional 401(k). I will state my case against the Roth 401(k) in this post.

The basic premise of a Roth 401(k), and to some extent a Roth IRA, is that of prepayment. You are prepaying the tax now so you don’t have to pay tax later. This prepayment concept is not uncommon. For example, buying a season ticket is prepaying for the individual events. Buying a timeshare is prepaying for vacation accommodation.

Whenever we deal with a prepayment scheme, we have to assess whether prepaying is “worth it.” The same paradigm also applies to Traditional versus Roth 401(k). There are several factors that make prepaying the taxes now not worth it.

1. Fill in lower tax brackets in retirement.

I showed in a previous post Commutative Law of Multiplication that if the marginal tax rate at retirement is the same as it is now, the Traditional and Roth 401(k)’s are equivalent. If the marginal tax rate is higher now than in retirement, one is better off contributing to a Traditional 401k. If the current marginal tax rate is lower, one is better off contributing to a Roth 401k.

But that applies only to the marginal dollar, which is the last dollar you can shift between Traditional and Roth 401(k). It is not necessarily the case for the entire contribution or the average dollar.

The tax system in the United States is progressive and it will probably stay that way. That means that income is taxed at increasing rates as it goes higher. Even if you think the marginal tax rate in the future will be higher, there will still be lower brackets and these lower brackets should be filled with money from a Traditional 401(k).

This chart below illustrates what the tax brackets are in 2008 for a married couple earning $100,000 between the two of them if they file jointly using the standard deduction (click on the chart to see it in full size).

* Source: Tax Policy Center

The first $17,900 of income is not taxed because it’s taken up by deductions and exemptions. The next $16,050 is taxed at 10%, the next $49,050 at 15%, the next $17,000 at 25%.

Because the way a Traditional 401(k) works, the dollars they contribute come off from the top, in the highest tax bracket for their income. After they retire, the dollars they receive from their Traditional 401(k) fill in from the bottom.

Even if we assume their marginal tax bracket in retirement will be higher due to tax increases, a large portion of the 401(k) withdrawal may still be taxed at a lower rate than what it was when they contributed the money. This is the same argument raised by a reader on the AllFinancialMatters blog.

Until you know you can generate from your Traditional 401(k) enough income to fill the lower brackets, it doesn’t make sense to contribute to a Roth 401(k). For people without a traditional defined benefit pension plan, it means the majority of the retirement savings should go to a Traditional 401(k), not Roth.

If you have a defined benefit pension plan and/or you expect to have a large balance in Traditional 401(k)/IRA, large enough to fill the lower brackets every year, then contributing to Roth makes some sense.

2. Avoid high state income tax.

Many people work in high tax states like California and New York today. They work there because there are a lot of well-paying jobs in those states. They won’t necessarily retire there because the high taxes take away a significant portion of their retirement income.

States popular with retirees like Florida and Texas have no state income tax. If you are working in a high tax state today but there is a chance you will retire in a no/low tax state, contributing to a Traditional 401(k) lets you avoid paying the high state income tax on the contributions. Prepaying the high state income tax now is a dead loss.

3. Leave the option open for Roth conversion in the future.

When you leave your employer, you can rollover the Traditional 401(k) to a Traditional IRA, which then can be converted to a Roth IRA at a later time when it is advantageous to you . A Roth 401k or IRA on the other hand can never be converted back to Traditional.

With a Traditional 401k, you hold the option, which has value. If you contribute to a Roth, you give up that valuable option. You can decide to convert and pay the tax whenever you are in a lower tax bracket than where you are now. Good times for conversion include:

• going back to school for a career change;
• becoming unemployed due to layoffs or burn-out;
• starting a business (not as much income in the first few years);
• two-income couple having one parent stay at home or work part-time for a few years after they have kids;
• a high-income single person marrying a lower-income spouse;
• taking early retirement;
• moving from a high tax state to a no/low tax state;

Unless you are sure that your marginal tax bracket will never be lower throughout your career, you should leave the option open by putting money in a Traditional 401(k) and then convert to Roth when an opportunity comes.

4. Avoid triggering phase-outs and AMT.

Because contributing to a Roth 401k does not reduce your gross income, you appear to be richer than you otherwise are if you contributed to a Traditional 401k.

There are all kinds of income-based eligibility cutoffs and phase-outs in the tax code. When your exceed the income threshold, your tax benefits from those programs are either reduced or eliminated. Some of these tax breaks include:

• child tax credit;
• Hope credit;
• Lifetime Learning credit;
• itemized deductions;
• personal exemptions;
• eligibility to contribute to a Roth IRA;
• eligibility to contribute to a Coverdell ESA

Think for example the tax rebate from the 2008 economic stimulus package. If a single person earned $90,000 in 2007 but contributed $10,000 to a Roth 401k, he/she is not eligible for the $600 tax rebate. If he/she contributed $15,000 to a Traditional 401(k) instead, he/she is eligible.

When your income appears to be “too high,” not only do you lose tax benefits, you may even trigger the AMT. Contributing to a Traditional 401(k) will help you qualify for tax benefits and escape or reduce the impact of AMT.

With so many disadvantages, then, for whom does a Roth 401(k) make sense?

A Roth 401(k) is good for people in low paying jobs now but expect to have high paying jobs later. Medical doctors in residence programs fit that description very well. They are paid very little while they are in residency but their income is expected to rise substantially higher when they finish the program. Their income will stay high in their career and they will receive a high income after they retire. Prepaying tax now makes sense because they are prepaying at a low rate now and they will avoid paying a higher rate later.

College students working part-time jobs or recent graduates working in entry-level jobs are also good examples for taking advantage of a Roth 401(k) while their income (and their tax rate) is low.

A Roth 401(k) is also good for people who are already in the top tax bracket and expect to be there forever. If they don’t see any chance of being in a lower tax bracket, prepaying tax now will lock in the tax rate so they won’t have to worry about future tax increases.

What about the idea of tax diversification? Some advocate both a Roth 401k and a Traditional 401k because the tax rates in the future are uncertain.

Diversification is good in general but it doesn’t mean automatic 50:50. Just like investing in emerging markets provides diversification, but it doesn’t mean you should invest 50% of your money in emerging markets. You still have to decide how much you should allocate your retirement savings between Traditional and Roth just like you allocate a portfolio between developed markets and emerging markets.

Tax diversification also doesn’t mean you have to do it right now if you are in your peak earning years. There might be better times coming up in the future.

As for me, I’m 100% in a Traditional 401(k). Prepaying tax now is just not worth it.

See also: Roth vs Traditional 401K on Bogleheads Forum.

[Update on May 16, 2008]: There is a follow-up to this post, Roth 401(k) for People Who Contribute the Max, which includes an online spreadsheet that calculates the value of having a higher effective contribution limit in a Roth 401k.

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Software picked, likely related articles at The Finance Buff:

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