Tax Diversification: A powerful strategy for long-term planning.
There’s a lot of talk about taxes these days, and for good reason: how you strategize and prepare for taxes can make the difference between a comfortable, stress-free retirement or acting as a significant drag on your wealth.
And while we talked about diversification in last month, this newsletter focuses on another critical type of diversification—tax diversification.
While asset class diversification is commonly understood, tax diversification is a powerful strategy for long-term financial planning and retirement.
A Brief Overview of Taxes
Before diving into tax diversification strategies, let’s clarify the different types of taxable income and how they’re treated.
Ordinary Income vs. Capital Gains
- Ordinary Income: This includes wages, salaries, interest income, and bonuses. It’s taxed at progressive rates, currently ranging from 10% to 37% in the U.S., depending on your income bracket.
Source: https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets
- Capital Gains/Losses: Capital gains taxes are applied when you sell assets, like stocks or real estate, for more than what you paid. Short-term capital gains (assets held for less than a year) are taxed at ordinary income rates, while long-term gains (assets held for more than a year) benefit from lower tax rates—0%, 15%, or 20%, depending on your income.
The Risk of Relying Solely on Tax-Deferred Accounts
As the year comes to a close, many people wonder how to lower their tax bill for the current year. Most tax professionals look back at the previous year’s income to minimize taxes. However, a forward-thinking tax strategy can have a much bigger impact on your future tax liabilities.
A common tax-saving method is to contribute heavily to tax-deferred accounts like 401(k)s and IRAs. While this offers immediate tax relief, it also sets up a future tax burden. The money in these accounts grows tax-deferred, but once you start withdrawing in retirement, it’s taxed at ordinary income rates, which may not be lower than what you’re paying today.
After working with clients for over a decade, I’ve seen that the majority of their investable assets are concentrated in tax-deferred accounts. While this may defer taxes, it doesn’t eliminate them. During retirement, this can become a significant issue—especially if you’re living on a fixed income.
Will you be in a lower tax bracket during retirement?
It’s possible but unlikely if you want to maintain your current standard of living. In retirement, your daily spending patterns might shift, and every day can feel like the weekend, which could mean more spending on leisure and lifestyle activities.
How to Diversify Taxes in Retirement
To implement tax-efficiency and increase flexibility in retirement, it’s essential to have a mix of taxable, tax-free, and tax-deferred accounts. This diversification gives you control over when and how your income is taxed.
Taxable Accounts:
These include brokerage accounts and investment portfolios. Although you pay annual taxes on the interest, dividends, and capital gains, a “spend-down” strategy lets you access both interest and principal. Since the principal isn’t treated as taxable income, you can reduce your tax liability.
Tax-Free Accounts:
This is where tax diversification becomes especially powerful. Roth IRAs are a great option for tax-free income in retirement. Contributions are made with after-tax dollars, and withdrawals, including earnings, are completely tax-free in retirement. However, Roth IRAs come with contribution limits. In 2024, you can contribute up to $8,000 if you’re over 50, but your ability to contribute directly is phased out if your income exceeds certain limits.
Even if your income is too high for direct contributions, a backdoor Roth IRA allows you to convert traditional IRA funds into a Roth. While this workaround is helpful, you’re still limited by the contribution caps, which may not be enough to fully meet your retirement income needs.
Why Tax Diversification Matters
How you take distributions in retirement has a significant impact on your tax bill. Let’s explore two scenarios, using the same amount—$300,000 in annual withdrawals—to illustrate the difference between relying solely on tax-deferred accounts and leveraging a tax-diversified strategy.
Scenario 1: All Income from a Tax-Deferred Account
In this scenario, a married couple withdraws $300,000 entirely from a tax-deferred account, such as a traditional 401(k) or IRA. Since this money hasn’t been taxed yet, the entire amount is considered ordinary income.
Here’s how the 2024 federal tax brackets for married couples filing jointly would apply:
- 10% on income up to $24,000
- 12% on income from $24,001 to $89,450
- 22% on income from $89,451 to $190,750
- 24% on income from $190,751 to $364,200
Here’s the tax breakdown:
- The first $24,000 will be taxed at 10%, which equals $2,400.
- The next $65,450 (from $24,001 to $89,450) will be taxed at 12%, which equals $7,854.
- The next $101,300 (from $89,451 to $190,750) will be taxed at 22%, which equals $22,286.
- The final $109,250 (from $190,751 to $300,000) will be taxed at 24%, which equals $26,220.
Total federal tax owed: $58,760.
Additionally, with taxable income exceeding the threshold, 85% of their Social Security benefits will also become taxable, further increasing their overall tax burden.
Scenario 2: Diversified Withdrawals from Tax-Deferred, Tax-Free, and Taxable Accounts
Now, let’s assume the same couple withdraws $300,000 but from a combination of sources:
- $100,000 (one-third) from a tax-deferred account (e.g., 401(k)),
- $100,000 from a tax-free account (e.g., Roth IRA),
- $100,000 from a taxable account, where $25,000 is a long-term capital gain and $75,000 is principal.
Here’s how the taxes would work out:
- Tax-Deferred Portion ($100,000): This is taxed as ordinary income, and the same tax brackets apply:
- The first $24,000 will be taxed at 10%, which equals $2,400.
- The next $65,450 will be taxed at 12%, which equals $7,854.
- The remaining $10,550 will be taxed at 22%, which equals $2,321. Total tax on this portion: $12,575.
- Tax-Free Portion ($100,000): Withdrawals from tax-free accounts, such as a Roth IRA, are not taxed at all. Total tax: $0.
- Taxable Portion ($100,000): Only the $25,000 long-term capital gain is taxable; the $75,000 of principal is not subject to tax. Long-term capital gains are taxed at a preferential rate:
- For a married couple with taxable income between $89,451 and $190,750, the long-term capital gains rate is 15%. Therefore, the $25,000 in gains will be taxed at 15%, which equals $3,750. Total tax on this portion: $3,750.
Total federal tax owed: $16,325.
Since the couple’s taxable income in this scenario is significantly lower ($125,000 in taxable income, which includes the tax-deferred withdrawal and the capital gain), it’s likely that none or only a small portion of their Social Security benefits would be subject to tax.
Comparison of Tax Impact
- Scenario 1 (all income from tax-deferred accounts): The couple owes $58,760 in federal taxes.
- Scenario 2 (tax-diversified withdrawals): The couple owes $16,325 in federal taxes.
By utilizing a tax-diversified strategy, this couple saves more than $42,000 in taxes while withdrawing the same $300,000. Additionally, the reduced taxable income minimizes or potentially eliminates the taxes owed on their Social Security benefits.
Conclusion: The Power of Tax Diversification
These examples demonstrate the dramatic difference tax diversification can make in retirement.
When all income is drawn from tax-deferred accounts, you face higher tax liabilities and risk pushing yourself into higher tax brackets.
On the other hand, by strategically drawing from a mix of tax-deferred, tax-free, and taxable accounts such as Roth IRAs, and taxable investment accounts with capital gains, you gain more control over your tax bill and preserve more of your income for retirement.
This approach can help reduce taxes and also offers flexibility in managing your retirement cash flow, making it easier to adapt to your evolving financial needs.
Please contact me if you have any questions or are ready to sit down and plan your future tax strategy!
-James DesRocher
TrueView Financial
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Investment Advisory Representative at Park Avenue Securities from 01-2015 to now: Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 800 Westchester Avenue, Suite N-409 Rye Brook, NY 10573, (914) 288-8800. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is a wholly-owned subsidiary of Guardian. TrueView Financial LLC is not an affiliate or subsidiary of PAS or Guardian. TrueView Financial LLC in not a registered investment advisor. CA Insurance License #0M83430
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