The traditional retirement savings paradigm has been—Defer…defer…defer. The theory of saving for retirement on a pre-tax basis is rooted in the idea that you are socking money away in your “prime earning years” and thus avoiding taxation on that money at high income tax rates. This theory presupposes that you will be in a lower tax bracket when you start withdrawing the funds you have saved in your retirement accounts. But what if we are in a rising income tax environment? What if you have done such a great job of saving, that the government’s mandated amount that you must withdraw (which begins at age 70) pushes you into that same bracket you were in in your earning years?
While the second question may be a good problem to have, “tax diversification” may be a good planning tool to make your retirement income plan more tax efficient. To achieve a tax-diverse savings, it can be a good idea to start an after-tax/taxable investment plan and/or look at starting or converting to a Roth IRA. It may also not be the best idea to wait on IRA withdrawals until age 70.
To achieve a “tax diversified” savings, annual evaluations should be made across all of your accounts taking under advisement the counsel of your tax advisor and your financial planner. These annual evaluations should begin in the years approaching your retirement, and continue through your first few years of retirement (when your taxes can vary widely). It is important to keep in mind that the taxation of your Social Security income is also highly dependent on your “other income.”
A Quick Breakdown on how the Various Types of Accounts fit into a Tax Diverse Plan:
Pre-Tax Plans (401k, IRA, 403b, etc.): These types of plans allow you to save on a pre-tax basis, meaning you lower your taxable income in your earning years. The assets grow tax-deferred, meaning you do not pay capital gains tax & ordinary income tax on the holdings as they grow. When you withdraw funds from these accounts, you are taxed as if you earned the income in that year; dollar for dollar. At age 70 ½ you the US Government requires that you begin withdrawing a determined amount from these types of accounts for the rest of your life.
After-Tax/Taxable Savings accounts: This is simply money set aside after you have paid income tax. Investments in these types of accounts are subject to capital gains tax & ordinary income tax as they accrue. It is for this reason that managing these accounts in a tax-sensitive way is important. Withdrawals from these types of accounts generally do not carry the same tax hit that pre-tax plans do because, generally speaking, you would be paying tax only on the growth of the asset, and typically at the capital gain rate.
Roth IRA: These types of accounts are funded with after tax dollars and growth accrues tax-deferred. Any withdrawals from these types of accounts are entirely income tax free.
It seems clear that have exposure across the different types of taxable accounts could potentially give your income plan the most flexibility.
