Tax Diversification is Key to Retirement Security

The bottom line in retirement income planning is that while the deferred taxation you enjoy from qualified retirement plans is great for capital accumulation, it can impact how much you can actually draw from it in retirement. Of course, a lot depends on your tax situation in both the accumulation and distribution phase of your retirement plan. But, assuming that you do well in accumulating retirement capital, you will likely find yourself in a similar tax environment when you’re ready to convert it to income. And, because it’s too late to do anything about it when you retire, you need to take action now to ensure your retirement is less taxing.

It helps to think of your investment options as different tax buckets. There can be a tax-free bucket consisting of tax-exempt bonds or a Roth IRA; there’s a tax-deferred bucket that would include your 401k or a Traditional IRA; and there’s a taxable bucket that would consist of any investment or savings vehicle that is currently taxed – either at ordinary income tax rates or capital gains tax rates.

A tax-diversified investment strategy includes a mix of all three buckets – and here’s why:

• With tax-free vehicles, what you receive as income is what you get. You don’t pay any taxes when it is received. However, you also didn’t benefit from any tax deductions when you contributed to the investment. For instance, with a Roth IRA, your investments grow tax-deferred, and after age 59½, they can be withdrawn tax-free; however, your contributions were made with after-tax dollars.
• With tax-deferred vehicles, such as a 401k or a Traditional IRA, you could deduct your contributions from your income, saving you money at the time. Still, upon withdrawal, your funds will be taxed at your ordinary tax rate.
• With taxable vehicles, you receive no tax deduction, and, depending on the type of investment, you pay taxes on interest or on capital gains as earned. Interest income is taxed at ordinary tax rates, while long-term capital gains are taxed at 20 percent at the highest. You don’t pay any taxes on unrealized capital gains, so, in essence, your investment portfolio can also be a tax-deferred vehicle if you never sell your securities. But even when you do, you can use losses in your portfolio to offset the gain and reduce your tax.

As you can see, with some vehicles, you can generate significant tax savings currently, which can be invested. With some vehicles, you forgo current tax savings to reap tax savings later. And with some, you may have to pay taxes as you go or when you draw from them in retirement, but it’s at a more favorable tax rate.

Tax Diversification Distribution Strategies

Assuming you’ve done well, and you find yourself in a higher tax bracket in retirement, you have some choices and flexibility in how you take your income from your three- tax buckets:

One strategy is to draw equally from all three allowing you to average your tax rate down through a combination of tax-free, taxable (at ordinary tax rates), and tax-favored (capital gains rate).

In years when you have a greater need for income, you could emphasize the tax-free or tax-favored account; in years when you need less income, with the possibility of falling into a lower tax bracket, you could emphasize your taxable income.

Remember, when you do draw from your tax-favored (capital gains) account, you can manage your tax liability by “harvesting” losses from your portfolio.

There is a major caveat: While there is the temptation to defer taxes from your qualified retirement accounts as long as possible, you need to be aware of the Required Minimum Distribution (RMD) rule, which requires you to withdraw a certain percentage of your income by age 73. If you have too much remaining in your accounts at that time, you could be forced to take out more than you need, pushing you into a higher tax bracket. There is no RMD with a Roth IRA, so you may consider reallocating more of your contributions from the tax-deferred bucket to the tax-free bucket, specifically your Roth IRA.

Another important caveat is that the tax code is very fluid – things can change, and your tax situation can change. But that is all the more reason you should have a diversified tax strategy, as it offers the greatest flexibility and opportunity to control your income in retirement.