Tax Diversification
Not all money is taxed the same. For many people, especially those nearing retirement, this fact often comes as a revelation and a motivation to make moves that can help lower their overall tax bill during retirement.
Tax diversification is a strategy that aims to reduce the concentration of investments in a single tax category. The goal is to create a balance of wealth among pre-tax, after-tax, and tax-free investment accounts in order to optimize tax efficiency and potentially enhance overall returns.
How Tax Diversification Works
Different accounts are taxed in different ways at the federal level. These differences offer you the flexibility to manage withdrawals efficiently and potentially lower your overall tax liability.
Pre-Tax Accounts: This is money saved through a workplace retirement plan such as a 401(k) or 403(b), or a traditional IRA. The IRS taxes this money when it comes out at your ordinary income tax rate. Ordinary income tax rates are often the highest rates, which makes the pre-tax bucket the least tax-efficient during retirement.
After-Tax Accounts: This is money invested in taxable or brokerage accounts. Tax rates on withdrawals can vary, but they can be managed so that you pay less than your ordinary income tax rate. For example, dividends from domestic companies and long-term capital gains are taxed at 15% or 20% depending on your annual income.
Tax-Free Accounts: Roth IRAs and Roth 401(k)s create a potential source of tax-free income for retirement. Money saved in a Roth account has already been taxed, so you do not pay taxes on qualified withdrawals.
Implementing a Tax Diversification Strategy
Tax diversification depends on balancing your liquid wealth across the three savings buckets. The sooner you can start building wealth in each of these categories, the better prepared you will be during retirement.
If most of your wealth is currently in pre-tax accounts, there are two primary strategies to consider:
1. Direct more savings to after-tax accounts. You can either invest extra money from your household budget in taxable accounts, or reduce how much you contribute to a 401(k) or IRA and redirect that money to a taxable brokerage account instead.
2. Convert pre-tax money to a tax-free Roth account. A Roth IRA conversion means you pre-pay taxes on your retirement income now instead of in the future. This strategy makes sense if you expect to be in a higher tax bracket during retirement, because withdrawals from pre-tax accounts are taxed as ordinary income.
Other Reasons to Consider Tax Diversification
Medicare Premium Payments. Many retirees are surprised to discover that Medicare Part B premiums are based on taxable income. A large annual RMD from a pre-tax account could mean you pay the maximum monthly premium for Medicare Part B. Even a small reduction in taxable income could produce significant savings on these costs.
Estate Planning Considerations. For non-spouse beneficiaries, inherited IRA assets are distributed over a 10-year period and taxed at the beneficiary's ordinary income tax rate. These distributions can create significant tax liabilities, ultimately leading to a loss of inherited wealth. Diversifying wealth in after-tax and tax-free accounts can help preserve more of what your beneficiaries receive.
The Widow's Tax. After the passing of one spouse, the surviving spouse files as a single taxpayer rather than married filing jointly. For single filers, tax brackets are narrower and the standard deduction decreases, which can increase the overall tax bill even with no change in income. Diversifying wealth away from pre-tax accounts gives a surviving spouse more flexibility to reduce their tax liability.
Rising Taxes. As federal government spending continues to grow and the budget deficit widens, it increases the likelihood that individual income taxes will rise at some point in the future. Tax diversification is one way to prepare for the possibility of higher income taxes down the road.