Tax diversification refers to spreading your investments across different accounts with varying tax treatments. Just as you diversify your investments to manage risk, tax diversification allows you to manage future tax liabilities.
Primary types of retirement accounts
When planning for retirement, you’ll need to understand the various retirement accounts available, each offering unique tax advantages and structures.
Tax-deferred accounts : Contributions are made pre-tax, reducing taxable income in the year of contribution. Withdrawals are taxed as ordinary income in retirement.
Tax-free accounts : Contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free.
Taxable accounts : These accounts don’t offer tax deferral but provide flexibility since capital gains are taxed at preferential rates, and withdrawals are not subject to required minimum distributions (RMDs).
Why Tax Diversification Matters in Retirement
Tax diversification is a crucial strategy to optimize your income and minimize tax liabilities during retirement.
Reducing required minimum distributions (RMDs) : Traditional retirement accounts require RMDs starting at age 73 or later. These distributions are taxed as ordinary income and can push you into higher tax brackets. Incorporating Roth or taxable accounts into your plan can lower taxable income and reduce RMD impact.
Managing Medicare premiums : Medicare Part B and D premiums are based on modified adjusted gross income (MAGI). Significant withdrawals from tax-deferred accounts can increase MAGI and result in higher premiums.
With tax diversification, you can strategically withdraw from tax-free or taxable accounts to avoid unnecessary premium hikes.
Optimizing Social Security taxation : Up to 85% of Social Security benefits can be taxable if your combined income exceeds certain thresholds. By withdrawing from Roth or taxable accounts, you can reduce taxable income and lower the portion of Social Security benefits subject to taxation.
Providing flexibility in tax policy changes : Tax laws change over time, and having multiple types of accounts gives you the flexibility to adjust your withdrawal strategy in response to new tax policies.
Strategies to Build Tax Diversification
Building tax diversification is an essential strategy for managing your retirement funds effectively.
Convert traditional IRA or 401(k) funds to a Roth IRA : Roth conversions allow you to move money from tax-deferred accounts into tax-free Roth accounts. While you’ll pay taxes on the converted amount, it may be beneficial to convert in years when you’re in a lower tax bracket.
Contribute to a Roth IRA or Roth 401(k) : If your income allows, contributing to a Roth IRA can build tax-free assets for retirement. Many employers now offer Roth 401(k) options, which allow you to contribute after-tax dollars while still benefiting from employer matches.
Utilize taxable accounts efficiently : While taxable brokerage accounts don’t offer tax deferral, they allow for more control over taxable income in retirement. Capital gains can be strategically realized at lower rates, and withdrawals are not subject to RMDs.
Withdraw from accounts strategically : In retirement, it’s often best to withdraw from taxable accounts first, tax-deferred accounts second, and Roth accounts last. This strategy allows tax-advantaged accounts to continue growing while minimizing immediate tax consequences.
Take advantage of tax-efficient investing : If using taxable accounts, focus on tax-efficient investments like index funds, municipal bonds, or ETFs that generate fewer taxable distributions.
Common Tax Diversification Mistakes
Introducing tax diversification strategies is crucial for optimizing retirement savings and ensuring financial flexibility amidst changing tax laws. Here are some mistakes to avoid.
Not considering Roth conversions early enough : Many people wait too long to start Roth conversions, missing the opportunity to convert at lower tax rates.
Over-reliance on tax-deferred accounts : Over-relying on tax-deferred accounts like traditional IRAs and 401(k)s can be a common pitfall for many investors planning for retirement. While these accounts provide immediate tax benefits—such as tax-deductible contributions and tax-deferred growth—they can lead to substantial tax burdens when it’s time to withdraw funds in retirement.
Ignoring taxable accounts : Many investors overlook the flexibility taxable brokerage accounts provide. Unlike tax-advantaged accounts, they provide easy access to funds without penalties or withdrawal restrictions, allowing immediate liquidity.
These accounts enable a broader investment strategy. They permit the trading of stocks, bonds, ETFs, and more.
Taxable accounts facilitate tax management strategies, like tax-loss harvesting, which can help reduce overall tax liability. They also allow the potential for a step-up in basis when assets are gifted or inherited, often minimizing capital gains taxes.
Failing to adjust withdrawal strategies : Tax laws change, and withdrawal plans should be revisited regularly to maximize efficiency.
Final thoughts
Tax diversification enhances retirement income, reduces tax burdens, and provides financial flexibility. By incorporating tax-deferred, tax-free, and taxable accounts into your retirement planning, you can optimize withdrawals and keep more of your savings.
If you’re unsure how tax diversification fits into your plan, working with a financial advisor can help tailor a strategy to your specific needs.
