A strategy those who are planning for retirement often overlook is tax diversification. Here, I talk about why you should learn about this and how to utilize it to stretch your retirement income.
In this article:
- How Tax Diversification Can Impact Retirement Planning
- Investment Vehicles: Different Individual Retirement Accounts and Their Pros and Cons
- Applying Tax Diversification in Retirement Planning
- Tax Diversification Strategy Options for Other Retirement Accounts
How a Tax Diversification Strategy Can Help Retirees Save More for Their Golden Years
How Tax Diversification Can Impact Retirement Planning
Most retirees may have heard about investment diversification. To minimize risk to their assets, investments and income streams, investors turn to asset allocation, wherein they strategically don’t put all their retirement eggs in one basket.
Diversification may help retirees stretch out their retirement savings as well in terms of taxes. Through tax diversification, retirees can diversify their taxes and potentially lower their tax bracket, tax rates, and taxable income?
A proper retirement plan should start with learning about how the tax treatment in different retirement accounts. This includes figuring out which of them are tax-deferred accounts and how they can influence your tax bracket.
Investment Vehicles: Different Individual Retirement Accounts and Their Pros and Cons
Here are some basic things about a Traditional IRA:
- It’s a tax-deferred account — Investors can report any contribution up to the limit as a tax deduction and they’ll pay taxes at the applicable tax rate upon withdrawal.
- Has required minimum distributions (RMD) — Upon reaching 70 and ½, a retiree MUST withdraw a minimum amount, which is 100% considered as taxable income, as the money grows tax-deferred. The investor can calculate this amount using worksheets provided by the IRS.
- Penalizes non-withdrawal of RMDs — Investors face penalties and fees if they don’t take required minimum withdrawals or contribute higher than the limits under the law.
The pros of a Traditional IRA include:
- Investors who assume they’ll be in a lower tax bracket upon retirement would pay lower tax rates when they eventually have to pay them upon withdrawal.
- Contributions lower taxable income, which also means a lower tax bracket and applicable tax rate for tax filing.
- Capital gains and income grows in a tax-deferred environment.
- An investor can have a traditional IRA in a brokerage account managed by a fiduciary or custodian. For those who want more control, they can opt for a Self-Directed Traditional IRA. In this type of account, investors have more freedom and control over what they invest in while still enjoying the tax benefits of a Traditional IRA.
On the other hand, the cons of a Traditional IRA include:
- Investors who end up in a higher tax bracket upon retirement will pay higher tax rates upon withdrawal.
- Investors still owe taxes upon withdrawal.
- Managed Traditional IRAs typically have administrative and miscellaneous fees that can eat up into one’s retirement savings.
2019 Traditional IRA Contribution Limits
For a Traditional IRA reportable for Tax Year 2019, contributions are at $6,000, with investors 50 and up able to contribute an additional $1,000. Going over the limit has dire consequences, so it’s important to be extra careful when dealing with an IRA.
Here are some basic things about a Roth IRA:
- Receives after-tax money — This means the IRS won’t tax the cost basis or original capital in a Roth IRA upon distribution since investors pay taxes upon contribution.
- Tax-free deductions — Any deductions by an investor after 59 ½ are tax-free. These also include both contributions and income, together with the rollover or transfer of funds. However, withdrawals from a Roth IRA that’s less than five years old will receive penalties and additional taxes.
The pros of a Roth IRA include:
- Investors who have the potential of being in a higher tax bracket upon retirement can save up on taxes by paying taxes while they’re still in a lower bracket.
- Once the Roth IRA reaches its 5th year, contributions and earnings may become tax-exempt.
- Any Roth distribution that meets the qualifications doesn’t increase tax liability. It also doesn’t affect Social Security, Medicare, and other programs.
On the other hand, the cons of a Roth IRA include:
- Roth IRA contributions don’t lower taxable income. This is because investors contribute using after-tax money.
- Investors who expect to have lower tax brackets in the future could end up losing money if they invest money taxed at a higher rate.
- Sometimes, investors are late at investing, with less than five years on the investment horizon. If this is the case, an investor wouldn’t be able to withdraw penalty-free from their Roth IRA until the 5th year.
2019 Roth IRA Contribution Limits
The contribution limits for Roth IRAs are just the same as Traditional IRAs. The limit is $6,000, with the catch-up provision for 50 and up with $1,000.
Roth IRAs don’t have an RMD, but investors can only have tax/penalty-free withdrawals on their IRA’s 5th year. The only time the IRS will require withdrawals for a Roth IRA is after the death of the account owner.
Applying Tax Diversification in Retirement Planning
To make the concept of tax diversification in retirement planning simpler, consider these sample scenarios.
- Sarah is a single taxpayer, 52 years old, at the tax bracket of 24% at $60,000 a year.
- Since she’s over 50 years old, she can start contributing $7,000, with the 2019 limit of $6,000 and the allowed catch-up amount of an additional $1,000.
Sarah invests in a Traditional IRA:
- Her taxable income drops to $53,000 since she can report the $7,000 contribution as a tax deduction.
- When she takes her required minimum distributions, the IRS will tax her income at 24%, assuming Sarah’s in the same tax bracket upon retirement.
She chooses a Roth IRA:
- Her taxable income remains at $60,000.
- Her $7,000 won’t affect her taxable income.
- If Sarah waits for five years, she may get her income tax-free.
She splits her income between a Traditional and Roth IRA:
However, if Sarah isn’t sure about her tax bracket in the future, she can contribute $3,500 to her Roth IRA and $3,500 to her Traditional IRA.
Since she may not be sure if her tax bracket at retirement is higher or lower, diversifying her taxable income might be more beneficial for Sarah.
Tax Diversification Strategy Options for Other Retirement Accounts
For those with employers, 401(k) matching contributions can kickstart one’s retirement investment journey.
Similar to a Traditional IRA, investors fund a 401(k) using pre-tax money. Employers match a percentage of the employee’s contributions as well.
Investors who want to diversify can have both an IRA and a 401(k). If we take the scenario above, consider if Sarah suddenly has to pay for something and she has both a Roth IRA and a 401(k).
Taking money from the Roth IRA to pay for the expenses may be better compared to the 401(k).
- Provided that her Roth IRA is five years old, the IRS won’t tax Sarah won’t when she withdraws.
- If she takes money out of her 401(k), the IRS will treat this as an early withdrawal (those made before the investor turns 591/2), and Sarah will have to pay taxes and penalties.
The longer the 401(k) remains, the better the returns, as the employer contributes more and money grow in a tax-deferred environment.
Note: There are certain exceptions that apply to the early withdrawal penalties for 401(k) accounts, including disability and financial hardship.
Lastly, a freelancer, self-employed individual, or small business owner can also consider a Simplified Employee (SEP) IRA, which you can fund using tax-free contributions.
Tax diversification, like investment diversification, can help an investor strategize how to save more for retirement. This can help them prepare better so they can enjoy and worry less during their golden years.
Do you have any questions about tax diversification? Do you think you’re on track with your retirement goals? Let us know your thoughts in the comments section below.