Tax Diversification in Retirement

As you know, diversification is important when it comes to asset allocation and investing. What you may not have heard is how equally important diversification is in tax location, especially when it comes to retirement income planning. Many retirees find themselves in high tax brackets during their retirement years because they failed to properly diversify their tax situation.

Most people save for retirement during their working years using tax-deferred retirement accounts such as 401(k)s or IRAs which reduce their income tax liability during the contribution years. Often, a retiree’s largest nest egg is located in these tax deferred vehicles where every dollar that is withdrawn is taxed at earned income rates.  Many retirees are shocked by the toll that taxes can take on the value of their investment portfolios when it comes time to access their money in retirement. That’s not all.  In addition to higher taxes, distributions from tax-deferred accounts can cause more of your Social Security to be taxed and your Medicare Part B premium to increase. The good news is that a little prudent planning today can help alleviate the tax burden in the future.

Tax diversification means having some of your assets in tax-deferred accounts (fully taxed upon withdrawal at earned income rates), some of your assets in Roth accounts (tax free upon withdrawal), and some of your assets in taxable accounts (earnings are taxed at a lower long-term capital gains/dividends rates, or are tax free in the case of municipal bonds).

One way to optimize your withdrawal strategy is to take just enough from the qualified account so that, combined with your Social Security and pension income, keeps you in the same tax bracket. This is a smart strategy because it minimizes the amount of tax you’ll pay on the most heavily taxed source of funds.

Then you take the remainder of the income you need partly from your non-qualified (a.k.a. taxable) account (15% tax on just the gains, if held for more than one year), and partly from your Roth IRA, tax-free.

In this scenario, you were able to get the money you needed, without moving into the next, higher tax bracket, and by paying tax rates that ranged from 0% to your marginal tax rate.

By contrast, if all of your money is in qualified accounts (as it is with most people), you’ll have no options — you must simply pay at whatever marginal tax bracket you happen to be when you make the withdrawals.

Therefore, making partial conversions from your Traditional IRA to Roth IRA after retiring but prior to turning 70.5 and being forced to take Required Minimum Distributions can be an effective strategy.  There are no income limitations on making conversions.  The ideal time to convert is when your ordinary income is lower, presumably right before or after retirement.

How much you withdraw from your investments may be the most influential factor in how long your money will last. Since every dollar you spend on taxes is one less you must spend in retirement, the goal is to minimize taxes and increase after-tax income. Tax diversification can help structure withdrawals to potentially reduce taxes and increase the amount of after-tax spendable income.

It’s not what you earn; it’s what you keep.