You are saving for retirement. You have a 401(K) plan, or an IRA, or even both, some savings and a financial plan in place to repay your mortgage before you retire. Kudos to you! You are well prepared. However, have you considered the tax implications of your retirement planning? If you are like most Americans, you probably haven’t. Retirement tax diversification is a topic that merits quite a bit of attention.
Retirement planning must include tax diversification. This is especially true if you assume that most people will be in a higher tax bracket when they retire than they are now.
You are probably familiar with the two most important and most commonly used retirement vehicles – a 401(K) and and IRA. These accounts can be classified as either “traditional” or “Roth”.
In a traditional IRA or 401(K), the contributions may be tax-deductible and the earnings can grow tax-deferred. With a Roth IRA or a 401(K), the contributions are not deductible, but future distributions can be tax-free, providing certain conditions are met. It’s important to note that in order to contribute to a Roth IRA, certain designated income limits cannot be exceeded.
Therefore, the rule of thumb is that if you think your tax bracket will be the same, or higher, during retirement, then the value of tax-free distributions from a Roth IRA or 401(k) may outweigh the benefits of the tax deductions you’d get from a traditional IRA or 401(k).
However, if you think your tax bracket will be lower in retirement than when you were working, a traditional IRA or 401(k) might be a better choice, due to the cumulative tax deductions you took at a higher tax rate.
Still, choosing between “Roth” and “traditional” may not be as straight forward. The good news is that you don’t necessarily have to choose – especially with an IRA. The reason being that you may still be able to contribute to both a traditional IRA and a Roth IRA, assuming you meet the Roth’s income requirements. By doing so, you could benefit from both the tax deductions of the traditional IRA and the potential tax-free distributions of the Roth IRA. Additionally, you may be able to contribute to a Roth IRA even if you are maxing out your company matching 401k plan.
Without a doubt, the most significant effect of “tax diversification” would come during your retirement years. More specifically, if you have money in different types of accounts, you could have flexibility in how to structure your withdrawals, and this flexibility can help you potentially increase the amount of your after-tax disposable income.
If you have a variety of accounts, with different tax treatments, you could decide to first make your required withdrawals (from a traditional IRA and 401(k) or other employer-sponsored plan), followed, in order, by withdrawals from your taxable investment accounts, your tax-deferred accounts and, finally, your tax-free accounts. Keep in mind, though, that you may need to vary your actual sequence of withdrawals from year to year, depending on your tax situation. For example, it might make sense to change the order of withdrawals, or take withdrawals from multiple accounts, to help reduce taxes and avoid moving into a different tax bracket.
Clearly, tax diversification for your retirement planning is very important as it will certainly be beneficial once you retire. So after consulting with your tax and financial advisors, consider ways of allocating your retirement plan contributions to provide the flexibility you need to maximize your income during your retirement years.