Dear Dr. Don,
It is my understanding that qualified (nonpenalty) distributions from 401(k) and traditional IRA accounts are taxable to the recipient at their ordinary/marginal tax rate at the time of receipt. However, qualified (nonpenalty) distributions from Roth IRA accounts are tax-free.

Does this mean that long-term capital gains in a 401(k) or traditional IRA end up being taxed at a potentially higher ordinary income tax rate? If so, is this a significant factor in evaluating whether to invest in a Roth IRA versus a traditional IRA or 401(k)?
— Don Distribution

Dear Don,
Your questions get to the heart of two much-discussed topics in retirement investing.

First: Is it better to defer taxes by contributing pretax dollars to a 401(k) or traditional IRA account, or contribute after-tax dollars to a Roth IRA and have qualified distributions be tax-free in retirement?

Second: Am I at a disadvantage in the tax-deferred accounts by having qualified distributions taxed at ordinary income rates?

Tax-deferred contributions to a traditional IRA or 401(k) plan should be taxed as ordinary income when distributed out of the account. That’s the deal. The question surrounds whether taxing the investment returns at ordinary income rates puts you at a disadvantage.

In part, it depends on your marginal tax rate when you take the distributions. Your ordinary income rate may be lower in retirement than it was during your career, mitigating the difference between the tax rate paid on ordinary income and the tax rate paid on long-term capital gains.

A Roth IRA front-loads the taxes because you’re contributing to the account with after-tax dollars. Because you’ve paid your income tax on the contributions, what’s left is the issue of taxation of the investment earnings when distributed out of the account as a qualified distribution. The federal government doesn’t tax these qualified distributions.

Which tax-advantaged retirement account is the better investment? That is somewhat subjective based on your current tax rates and the tax rates you expect to pay in retirement.

You should also consider how much of your portfolio is invested in taxable accounts. In general, you want to hold tax-efficient investments in your taxable accounts and tax-inefficient investments in your tax-advantaged accounts.

If your company offers matching contributions in the 401(k) plan, it makes sense to contribute up to the limits of the company match. Past that point, your eligibility to contribute to a Roth IRA or a traditional IRA will influence where your remaining retirement savings can go.

Changes to the tax code will allow you to convert a traditional IRA to a Roth IRA in 2010 and beyond without the income limitation currently in place on conversions. See IRS Publication 590, Individual Retirement Arrangements, for additional details.

There’s an argument for tax diversification, where you contribute some monies to a Roth IRA and other retirement monies to other types of tax-advantaged retirement accounts and even to a taxable account. The logic behind this approach is that you don’t know what tax rates you’ll face in retirement, so by mixing it up you don’t have too much exposure in any one type of retirement account.

Your income, age, risk tolerance and the type of investments planned for your retirement portfolio will determine the best approach for you. Consult with your tax professional for additional guidance.

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