Tax diversification is a strategy that uses accounts with different tax treatments to give you more flexibility and control over your taxes in retirement. By diversifying your savings across tax-deferred, tax-free, and taxable accounts, you can reduce your tax burden and increase your after-tax income in retirement.
The Benefits of Tax Diversification
Taxes can have a significant impact on your retirement income. Depending on your income level, current tax laws, and spending needs, you may face significantly different tax rates in retirement. That’s why it can be helpful to diversify your tax exposure and prepare for various possibilities. By having a mix of the following types of accounts, you can optimize your tax savings and plan your withdrawals more strategically:
- Tax-deferred accounts, such as IRAs, 401(k)s, 403(b)s, 457(b)s, pension plans, and annuities, are funded with pre-tax dollars and offer tax-deferred growth until you withdraw your money in retirement. These accounts can help you lower your current taxable income and take advantage of compound interest. However, you also have to pay ordinary income taxes on your withdrawals, which can be higher than capital gains taxes, and you may face penalties and taxes if you withdraw before age 59 ½ or fail to take required minimum distributions (RMDs) after age 72 or 73. Tax-deferred accounts are most attractive for those who think their tax rate will be higher during their peak years than in retirement.
- Tax-free accounts, such as Roth IRAs, Roth 401(k)s, health savings accounts (HSAs), and 529 education savings plans, are funded with after-tax dollars, but offer tax-free growth and withdrawals, as long as you follow certain rules. These accounts can help you avoid taxes in retirement, especially if you expect to be in a higher tax bracket or face higher tax rates. However, you also have to pay taxes upfront, which can reduce your current cash flow and savings potential. These accounts are most attractive for those who think their tax rates will be higher in retirement. For high earners who have maxed out their tax-deferred savings (e.g. hit the 401(k) contribution limit) tax-free accounts are a great way to get even more money into tax-advantaged savings vehicles.
- Taxable accounts, such as brokerage accounts, bonds, stocks, checking accounts, and savings accounts, are funded with after-tax dollars and are subject to capital gains taxes and income taxes on dividends and interest. These accounts offer more flexibility and liquidity, as you can access your money at any time without penalties or taxes. However, you also have to pay taxes on your earnings every year, which can reduce your returns over time.
An Example of Tax Diversification
Let’s look at an example to illustrate the potential benefits of tax diversification. Let’s look at Bob and Jane, a married couple both age 65 who file their taxes jointly. They have the following assets and income/spending needs:
- Social Security Benefits of $40,000
- $1,000,000 Roth IRA
- $1,000,000 Rollover IRA
- The couple wants to withdraw $100,000 annually from retirement accounts to meet spending needs
The following shows 4 different withdrawal scenarios for this couple and how they affect their tax bill:
As you can see, varying the amount of taxable withdrawal has a significant impact on the couple’s tax bill. Not only are the IRA withdrawals taxed, but they also increase the amount of social security benefits that are taxable. It’s worth noting this is an oversimplified example as the actual withdrawal would need to be higher from the IRA to have the same after-tax dollars available to the couple as a withdrawal from the Roth account.
Capital gains are another consideration for those who can do significant tax planning around retirement as capital gains tax rates for a married filing jointly couple is 0 when their adjusted gross income is $89,250 or less (for 2023). This means the couple could potentially withdraw more from their taxable accounts without paying any taxes on their capital gains, as long as they stay within the income threshold.
Tax diversification allows this couple to be strategic with their withdrawals. Ideally, this couple would devise a strategy for the sequence of their withdrawals that minimizes their taxes over time.
How to Achieve Tax Diversification
There is no one-size-fits-all formula for tax diversification, as it depends on your financial situation, goals, preferences, and opinion of future tax law. Most saving for retirement have the bulk of their savings in tax-deferred vehicles like a traditional IRA or 401(K). To achieve tax diversification for most means increasing their savings into Roth accounts. But this might not make sense in all situations.
For high earners with the ability to save more, contributing to Roth IRAs with strategies like backdoor Roth contributions or mega backdoor Roth contributions is a great way to go. HSAs for future medical expenses or 529 plans to help save for loved ones’ education can also be helpful tools.
It’s a little more complicated when you don’t have additional funds to save for retirement and instead are considering saving into a Roth instead of a traditional 401K or IRA. If your tax rate today is going to be higher than your tax rate in retirement, then you’re better off sticking with the traditional tax-deferred savings. However, this involves an unknown variable as tax law changes frequently and we don’t know what future tax rates will be.
Because of the uncertainty over future taxes, I often prefer receiving the tax benefit earlier. As the proverb says, a bird in the hand is worth two in the bush. I think there’s a risk that Roth IRAs are mean tested or have other restrictions put on them in the future, which could reduce their effectiveness.
Tax diversification can be a smart strategy that will prepare you for an uncertain future and provide you with the flexibility to optimize your situation. By diversifying your savings across tax-deferred, tax-free, and taxable accounts, you can reduce your tax burden and increase your after-tax income in retirement. A qualified financial advisor or tax professional can be a significant help in coming up with the best plan for you.
If you want to learn more about tax diversification and how it can benefit you, please contact us today. As both a CPA and financial advisor I love working with clients to come up with solutions that save them the most money. I’d love to hear from you and help you plan for a successful and tax-efficient retirement.
Scott Caufield, CFA, CPA