Experienced investors understand that diversification is key. But as we save for retirement, it's also a good idea to diversify how and when your savings will be taxed. It means taking advantage of different types of investing and savings accounts that are taxed differently for federal and state income tax purposes. The ultimate goal is to pay taxes on income when the applicable rate is lowest. Today's rates are relatively low by historical standards, and it's conceivable they could rise before or during your retirement.
Tax diversification in retirement can be challenging. There are a number of unknowns to consider like future tax laws, your longevity, and your post-retirement income needs from your retirement savings, Social Security, pensions, nonretirement investments, and other potential sources of income. Determining the right strategy for you will depend on several factors, including your current tax rate, your tax rate in retirement, and how much flexibility you need when making withdrawals in retirement. Each has its own unique tax considerations, and it would be wise for you to consult with your accountant or tax professional on the best strategy for your retirement goals.
For our purposes here, we will look at four primary types of taxable and tax-deferred accounts that can impact your taxable income in retirement, and that you can use to diversify your tax exposure:
1. Tax-deferred retirement accounts
If your employer offers matching contributions to your retirement account, then your first priority should be to save enough to get the full match. The pretax contributions to your 401(k), 403(b), or traditional IRA (Note: IRA deductions are dependent on your income) reduce your taxable income in the year you make the contribution. These contributions and their gains are not taxed until retirement, at which time withdrawals are subject to current income tax rates. You should also keep in mind that the IRS currently requires you to take required minimum distributions (RMDs) from your tax-deferred savings accounts each year starting at age 73. (Note: If you're still working and remain on your current employer's plan, then RMD rules do not apply to your current employer-sponsored retirement account. However, RMDs from IRAs and plans sponsored by your former employer(s) are still required, working or not.)
2. Roth accounts
For some savers, it is possible that their retirement income could exceed their working wages. To avoid higher taxes in retirement, you may want to consider paying some taxes earlier. A Roth conversion during your working years may be a great method of providing greater tax efficiency in retirement. You can convert all or a portion of funds from a traditional IRA to a Roth IRA and pay ordinary income taxes on the converted amount in the year of the conversion. (Note: It may be advantageous to perform several Roth conversions over multiple tax years to avoid a higher tax bracket.)
Unlike tax-deferred accounts, contributions to Roth 401(k)s and Roth IRAs are made with after-tax dollars, so they won't reduce your current taxable income. But when you withdraw the money in retirement, you won't owe taxes on appreciation, income, or withdrawals.
A Roth IRA is also exempt from RMDs (unless you inherit it). A Roth 401(k) is not exempt currently, but SECURE Act 2.0 eliminates Roth 401(k) RMDs starting in 2024. For 2023, to make a direct contribution to a Roth IRA, single filers must have a modified adjusted gross income of less than $153,000, and contributions are reduced starting at $138,000; for those married and filing jointly, the figures are $228,000 and $218,000.
3. Taxable investment accounts
Traditional bank and brokerage accounts are also funded with after-tax dollars. Tax-efficient investments such as Exchange-traded funds (ETFs), index mutual funds, and tax-managed funds typically don't create as many taxable distributions as actively managed funds. Tax-advantaged municipal bonds (Munis) are also an option if you're in a high tax bracket. Interest paid on Munis is typically free from federal taxes. If issued in your home state, they are usually free from state and local taxes as well.
With brokerage accounts, you can sell securities and contribute or withdraw money at any time and for any reason without incurring penalties. Taxable investment income is taxed in the year it's earned, however, and investments sold for a profit are subject to capital gains taxes. But if you sell an investment for a loss, then you may be able to use it to offset any gains—and/or up to $3,000 of ordinary income. This is known as tax-loss harvesting. Brokerage accounts are also exempt from RMDs.
Holding appreciated investments for more than a year allows you to take advantage of long-term capital gains rates, which range from 0% to 20% depending on your income. More frequent trading can potentially create a "tax drag" that can reduce your after-tax returns by 1% to 3% annually.
4. Health Savings Accounts
Most of us will face increased medical expenses after retirement. Although not traditionally considered retirement accounts, if your employer offers a health savings account (HSA) and you are covered by a high-deductible health plan, then it can be an effective tax savings vehicle. Contributions reduce your taxable income and grow tax-free. You also pay no tax on withdrawals for qualified medical expenses. In 2023, individuals can contribute up to $3,850, families can contribute up to $7,750, and account holders age 55 or older can contribute an additional $1,000. Employers sometimes provide matching contributions, though they'll count against the annual limits. HSAs are also exempt from RMDs.
Anticipating future tax rates as well as your personal situation in retirement can still involve guesswork. But with a number of different account options available to you now, there is potential to build in flexibility and a level of control over future tax bills in retirement.
Thanks for reading.
This material has been provided for general, informational purposes only, represents only a summary of the topics discussed, and is not suitable for everyone. The information contained herein should not be construed as personalized investment advice or recommendations. Rather, they simply reflect the opinions and views of the author. D. B. Root & Company, LLC. does not provide legal, tax, or accounting advice. Before making decisions with legal, tax, or accounting ramifications, you should consult appropriate professionals for advice that is specific to your situation. There can be no assurance that any particular strategy or investment will prove profitable. This document contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information derived from such sources, and take no responsibility therefore. This document contains certain forward-looking statements signaled by words such as "anticipate," "expect", or "believe" that indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward-looking statements. As such, there is no guarantee that the expectations, beliefs, views and opinions expressed in this document will come to pass. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. All investment strategies have the potential for profit or loss. Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The impact of the outbreak of COVID-19 on the economy is highly uncertain. Valuations and economic data may change more rapidly and significantly than under standard market conditions. COVID-19 has and will continue based on economic forecasts to have a material impact on the US and global economy for an unknown period.
Chief Planning Officer
Nancy I. Kunz
CFP®, CPFA®, ChFC®, CLU®