When people are saving for retirement, their main focus tends to be how much they’re putting away and how their investments are performing. What is often missed is how your retirement savings will be taxed when you start taking money out. How much you’ve saved matters, but how much of that money you’ll actually have available to spend is just as important. By spreading your retirement savings across accounts with different tax treatments, you may be able to manage your tax burden more effectively and make your money work a little harder in retirement.
What is tax diversification?
You’ve probably heard plenty about portfolio diversification (managing risk by spreading your money across different types of investments). Tax diversification instead focuses on how that money is taxed. Retirement savings usually fall into three categories:
- Tax deferred accounts, which allow you to contribute pre-tax or deductible dollars and postpone income taxes until you withdraw the money (e.g. traditional 401(k)s and traditional IRAs).
- Tax-free accounts are funded with after-tax dollars. While you don’t receive an upfront tax deduction, qualified withdrawals from these accounts in retirement are generally tax-free (e.g. Roth IRAs and Roth 401(k)s).
- Taxable investment accounts don’t offer the same retirement-specific tax benefits, but they tend to have fewer withdrawal restrictions. Taxes may apply to dividends, interest, and realized capital gains (e.g. brokerage accounts).
Each type of account has its own advantages and limitations, which is why it’s important to understand how they can work together.
Why tax diversification matters in retirement.
One of the biggest challenges in retirement planning is that we don’t know what tax rates will look like 10, 20, or 30 years from now. Your income may vary. The amount you need to withdraw from your savings may fluctuate from one year to the next. Tax laws may change as well. If your retirement nest egg is only in tax-deferred accounts, most withdrawals will be subject to ordinary income tax. That can make it harder to manage your taxable income, especially in years when you need extra money. Spreading savings across different account types can help you avoid relying entirely on one tax treatment.
More control over unexpected expenses.
Imagine you’re retired and need to replace your roof, purchase a new vehicle, or cover an unexpected expense. If the only account you have to withdraw from is a traditional IRA or 401(k), taking out the additional money to cover the expense could increase your taxable income for the year. Depending on your circumstances, it may also push some of your income into a higher tax bracket or affect other income-related costs. Alternatively, if you have the option to pull those funds from a Roth account or taxable brokerage account instead, you may be able to cover the expense with a smaller tax impact.
Managing taxes from year to year.
Retirement income isn’t always as predictable as people expect. Some years, you may have more income from investments, pensions, or other sources. Other years, your taxable income may be lower. If you are proactive, you can use this income variability to manage your taxes. In a year when your taxable income is relatively low, it might make sense to withdraw from a traditional IRA or consider a Roth conversion. In a year when your income is already high, using qualified Roth withdrawals can help you avoid adding more to your year-end tax bill. It may also be beneficial to withdraw the funds for a taxable investment account, depending on your capital gains and losses.
How tax diversification affects Social Security and Medicare.
The way you withdraw money from your retirement accounts can affect more than just your tax bill. Depending on your overall income, withdrawals from traditional retirement accounts may increase the portion of your Social Security benefits subject to federal income tax. Higher-income retirees may also pay additional premiums for Medicare Part B and D. The rules can be complicated, and the impact depends on your individual situation, but it’s an important consideration in your overall retirement strategy.
Required Minimum Distributions (RMDs).
Traditional IRAs and most traditional 401(k) accounts are subject to RMDs once you reach the applicable age. That means the IRS requires you to withdraw a certain amount each year, whether you need the money or not. Those withdrawals can increase your taxable income and potentially affect other parts of your retirement finances. Tax-free accounts aren’t subject to lifetime RMDs for the original account owner under the current rules. Building Roth savings alongside traditional retirement accounts may help reduce the impact of required distributions when that time comes.
Finding a balance.
Whether you should be contributing to a traditional retirement account, a Roth account, or a taxable brokerage account depends heavily on your specific circumstances. Your current tax bracket, expected retirement income, retirement timeline, and overall financial situation all play a role. It’s important to utilize tax diversification as a strategy and find a balance that fits your financial circumstances and long-term goals. If we can be of any guidance along the way, don’t hesitate to reach out.
Frequently asked questions.
Is it better to contribute to a traditional or Roth retirement account?
It depends on your current tax situation and what you expect your taxes to look like in retirement. Traditional retirement accounts may offer tax benefits today, while Roth accounts can provide tax-free qualified withdrawals later.
Can I contribute to both a traditional IRA and a Roth IRA?
Yes, depending on your eligibility and the accounts available to you. Keep in mind that contribution limits and income restrictions may apply, and some account types share annual contribution limits.
Should I convert my traditional IRA to a Roth IRA?
A Roth conversion may make sense in certain situations, but the converted amount is usually subject to income tax in the year of conversion. It’s important to consider the immediate tax cost alongside the potential long-term benefits.
Does tax diversification help reduce Medicare premiums?
It may, since certain retirement withdrawals can affect the income used to calculate Medicare premiums. Qualified Roth withdrawals generally don’t increase that income, which may help you manage those costs.
Do I still need taxable investment accounts if I have a 401(k) and IRA?
Taxable accounts can be useful for accessing money without retirement account withdrawal restrictions. Whether they’re appropriate depends on your savings goals, tax situation, and overall financial plan.
Disclaimer: The information above is for general educational purposes only and should not be considered financial, tax, or legal advice. Always consult with a qualified professional regarding your specific situation. You should consult with your CPA and/or attorney before implementing any estate planning, gifting, or tax-related strategy.