Conventional wisdom says that you will likely be in a lower income tax bracket during retirement than during your earning years. That's why you invest pretax dollars now and defer the tax bill until those dollars are withdrawn during retirement. But tax reforms could alter tax brackets in the future. Tax diversification is a strategy that may help you manage this uncertainty.
Here's the concept: Spread your investments among accounts with different tax structures so that you have the flexibility to manage the tax liability of your assets during retirement.
There are three main types of retirement accounts:
Taxable. Investments in this category generate taxable interest, dividends and capital gains.
Tax-deferred. Interest, dividends and capital gains accumulate tax-deferred in these accounts. But once you start withdrawing money, you'll generally have to pay income tax on the amount you receive at your ordinary tax rate unless you move it to another plan or IRA in a qualified rollover.
Tax-free. With Roth accounts, contributions are made with after-tax dollars. After you've reached age 59½ and had your account for five tax years, qualified distributions — including earnings — are tax free. By investing in different types of accounts, you have the flexibility during retirement to withdraw assets from whichever account has the most beneficial tax terms for your situation at that time.
Each of these vehicles carries its own features, benefits and risks. One or more
may be right for your portfolio, depending on your goals, time horizon, risk tolerance
Tax Treatment of Retirement Accounts Differs
Savings and brokerage accounts, mutual funds
Contributions are made with after-tax dollars. Taxation occurs annually on earnings.
Traditional IRA, 401(k), 403(b)
Contributions are made with pretax dollars. Taxation occurs on earnings and contributions when withdrawn. If withdrawn prior to age 59½, may be subject to an additional 10% federal income tax penalty.
Roth IRA or Roth options within a 401(k) or 403(b)
Contributions are made with after-tax
dollars. No further tax on contributions
and earnings when withdrawn.1
1 Assuming withdrawals meet requirements for tax-free treatment. Earnings can be withdrawn tax and penalty free if held for five years and withdrawn after age 59½. Other qualified distributions include a maximum of $10,000 for the purchase or rebuilding of a first home for the Roth IRA holder or a qualified family member, distributions due to disability, and the distribution of assets to the beneficiary of the Roth IRA holder after his/her death.
Talk to your financial advisor or tax advisor about these ideas for diversifying your tax liabilities and whether they're right for you:
Keeping an emergency fund in a liquid, taxable account.
Investing in your employer's 401(k) or other tax-deferred plan.
Contributing to a Roth IRA, if eligible.
Converting a Traditional IRA into a Roth IRA, if you hold multiple Traditional IRAs.
If you're already in, or quickly approaching, your retirement years, and you have assets in multiple accounts, talk to your advisor about the best approach for withdrawing your assets. Your withdrawal strategy can greatly affect your tax liabilities.