Planning for retirement involves more than just saving money and investing wisely—it also requires proactive tax planning. Just as you diversify your investments to minimize risk and boost potential returns, diversifying your retirement savings across different tax environments can help you keep more of your hard-earned money when you retire.
This strategy, known as tax diversification, is an essential, yet often overlooked, component of a comprehensive retirement plan. In this article, we’ll explore what tax diversification is, why it matters, and how you can incorporate it into your retirement income plan.
How Tax Diversification Works
Tax diversification involves distributing your retirement savings across different types of accounts with unique tax implications. The objective is to create a balance between tax-deferred, tax-free, and taxable accounts.
This approach offers more control over your retirement income strategy, potentially saving you a significant amount of money in taxes. To achieve effective tax diversification, you’ll generally want to allocate your retirement savings across three tax “buckets”:
- Tax-Deferred Accounts (Traditional IRAs, 401(k)s). You contribute pre-tax dollars to these accounts, reducing your current taxable income. Then, you pay ordinary income taxes on any withdrawals you make in retirement.
- Tax-Free Accounts (Roth IRAs, Roth 401(k)s). You contribute after-tax dollars, but withdrawals are tax-free in retirement.
- Taxable Accounts (Taxable Brokerage Accounts, Savings Accounts). You contribute after-tax dollars and pay capital gains taxes on any earnings when you sell investments for a profit.
The Importance of Tax Diversification
The key benefit of tax diversification is flexibility. By having a mix of accounts, you can strategically draw down your savings in retirement to minimize your tax bill.
For instance, if you anticipate a higher tax rate one year, you might choose to withdraw from a Roth or taxable account to avoid pushing yourself into an even higher tax bracket. Alternatively, in lower-income years, you might take distributions from tax-deferred accounts or convert part of your traditional IRA to a Roth account.
In addition, tax diversification can help mitigate the risk of future tax law changes that can negatively impact you in retirement.
Indeed, legislative changes, shifting political landscapes, and ongoing efforts to respond to the evolving needs and challenges of the economy make it challenging to predict your future tax rate. However, diversifying your account types can help you navigate tax law changes more effectively and preserve more of your hard-earned financial resources.
How to Achieve Tax Diversification
The earlier you start thinking about tax diversification, the better. In most cases, your working years give you more flexibility to contribute strategically to tax-deferred, tax-free, and taxable accounts.
If you meet the income requirements to contribute to a Roth IRA or 401(k), consider splitting your retirement savings between traditional and Roth accounts up to their respective limits. This approach allows you to balance immediate tax savings with future tax benefits.
For example, if you’re currently in the 24% tax bracket and you contribute $10,000 to a traditional 401(k), you’ll reduce your current year’s tax bill by $2,400. But if you contribute the same amount to a Roth 401(k), you give up immediate tax savings so future withdrawals are tax-free.
Generally, it’s a good idea to contribute as much as you can to Roth retirement accounts while you meet the income requirements. Since these types of accounts offer tax-free withdrawals in retirement and have no required minimum distributions (RMDs), they provide even more flexibility when developing your retirement income strategy.
Lastly, don’t overlook the benefits of contributing to a taxable brokerage account, especially if you have extra cash to put to work. These accounts allow you to pay the lower long-term capital gains rate on any realized earnings and, like Roth accounts, don’t have RMDs. Plus, you can access your funds any time without penalty, offering additional flexibility.
Tax-Efficient Investment Selection
In addition to diversifying your retirement savings across different account types, it’s also important to consider tax efficiency when choosing specific investments. This strategy, known as asset location, can further enhance your tax savings.
Here’s how a tax-efficient asset location strategy might work in practice:
- Tax-Deferred Accounts. A traditional IRAs or 401(k) can be an appropriate place for investments that generate a lot of taxable income, like taxable bond funds. Since you won’t pay taxes on earnings until you start taking distributions from these accounts, you can reinvest the income these investments generate and benefit from tax-deferred compound growth.
- Tax-Free Accounts. Roth accounts tend to be the best location for investments that you expect to experience significant growth over time—for example, stocks and other high-growth investments—since you won’t have to pay taxes on future earnings.
- Taxable Brokerage Accounts. These accounts are typically suitable for holding tax-efficient investments and assets that generate tax-advantaged income. For instance, municipal bonds are often a good fit for taxable accounts since their interest income is typically exempt from federal income taxes and possibly state taxes.
Of course, tax efficiency is just one factor to consider when developing your investment approach. However, strategic asset location can help you reduce your tax bill even further in retirement, potentially preserving your savings longer.
Chladek Wealth Management Can Help You Develop a Tax-Efficient Retirement Income Strategy
While tax diversification provides multiple benefits, it does come with its challenges. Achieving a balanced tax portfolio requires careful planning, a good understanding of your financial situation, and staying informed about ever-changing tax laws.
It’s also important to keep in mind that tax diversification doesn’t eliminate taxes—it only defers or minimizes them. It’s essential to plan your retirement distributions carefully to avoid unexpected tax burdens in the future.
At Chladek Wealth Management, our goal is to help you maximize your hard-earned savings and enjoy a comfortable retirement. As a fiduciary, fee-only financial planner, we understand the complexities of tax diversification and its crucial role in retirement planning. We can help you develop a comprehensive financial plan that helps you achieve your retirement goals while minimizing your lifetime tax bill.
If you’re preparing for retirement, let’s discuss how tax diversification can enhance your financial plan. Schedule a Free Financial Assessment today to learn more.