Tax diversification is the practice of saving for retirement through a variety of retirement vehicles with different tax treatments. Instead of putting all your eggs in one basket, you spread your savings out among types of accounts to minimize your tax bill as much as possible. Working with your CPA or CFP should help you determine the correct strategy for your retirement plan.
Some types of accounts you can use to accomplish this are:
- Traditional 401(k), 403(b) or IRA: You get a tax deduction when you contribute but have to pay taxes when you withdraw the money in retirement. The government requires you to take required minimum distributions at age 72 (or age 70.5 for those born before July 1, 1949).
- Roth 401(k), 403(b) or IRA: You do NOT get a tax deduction when you contribute, but funds grow tax-free, qualified withdrawals are tax-free and there are no required minimum distributions.
- Taxable savings or brokerage account: You pay tax on any dividends or interest yearly and on capital gains when you sell.
With this information in mind, here are five strategies for achieving tax diversification, maximizing your retirement income and minimizing your future tax obligations.
Strategy #1: Contribute to a Roth IRA or 401(k)
If you’ve got earned income and are within government limits for Roth IRA contributions, the biggest favor you can do your future retired self is to make Roth IRA contributions. Maximum Roth IRA contributions are $6,000 for 2019, unless you are 50 or older, in which case you can contribute $7,000. Your ability to meet those maximum contributions, however, can phase out dependent upon your income level. You have until April 15, 2020, to make a contribution for 2019.
Strategy #2: Make a Non-Deductible IRA Contribution
If you make too much money to contribute to a Roth, you can still make a non-deductible contribution to your traditional IRA. The catch is that you need to maintain records of your non-deductible IRA contributions so that you will know what amounts you don’t have to pay taxes on when you withdraw money in retirement.
Strategy #3: Convert traditional IRA savings to a Roth IRA
When you convert money from a traditional IRA to a Roth IRA, you must pay taxes on the amount you can convert. Why? Because you received a tax deduction when you made that original contribution.
Converting savings to a Roth gets the tax bill out of the way now that you would otherwise pay later in retirement. At that point, tax brackets may be higher. Also, it means the money in the Roth can grow tax-free throughout your retirement because there are no required minimum distributions.
Strategy #4: Begin taking distributions in your 60s
While you don’t have to begin traditional retirement account withdrawals until after age 72 (or 70½ if you were born before July 1, 1949), taking smaller distributions beginning during your 60s spreads the tax bill over more years.
This strategy can also help you stay in a lower tax bracket and reduce your lifetime tax bill. Withdrawals from tax-deferred accounts are taxed at ordinary income rates, rather than more favorable capital gains tax rates.
Strategy #5: Contribute to taxable accounts
If you’ve got money to contribute to savings beyond what you are already saving in your 401(k) and Roth IRA, taxable accounts are a great idea. You can invest in virtually any type of investment, such as Individual Brokerage Accounts, Municipal Bonds or even High Yield Money Market accounts, and you don’t have to worry about required minimum distributions. There is also no maximum contribution limit. With taxable accounts, you are only taxed on the portion of the gains of the account. With that in mind, when these taxable investment accounts pay out qualified dividends, such as those that come from most stock and mutual fund accounts, you typically pay at a lower tax rate.
A final word
Ultimately, we know there is no way to avoid taxes altogether, but we need to use the proper strategies to mitigate the tax burdens we are sure to face during retirement.