Tax diversification can help you save. Here's what to consider with your retirement funds.
Medora Lee, USA TODAY
5 min read
It’s tax season, and people who are busy making last-minute contributions to retirement funds to take advantage of tax benefits this year might be forgetting to consider where they’re putting money.
Different types of retirement accounts offer different tax advantages in retirement. How and when you withdraw money from various accounts can determine how much you pay in taxes, so diversifying the types of accounts is just as important as diversifying the types of investments you make.
"Every dollar you lose to taxes is one less dollar in your pocket,” said Maria Bruno, Vanguard’s head of U.S. wealth planning research. “Holding different account types helps manage uncertainty around future tax rates because we don’t know in 20 to 30 years, what the tax regime will be or what your personal tax rate might look like.”
Jeremiah Barlow, Mercer Advisors’ head of family wealth services, had a client who retired, didn’t yet have to take required minimum distributions or social security, and paid zero taxes on $100,000 from a taxable account.
The client stopped working, and the couple’s income fell sharply, allowing the client to take $100,000 from a taxable account and take some deductions to push income below the threshold ($44,625 for individuals and $89,250 for joint filers in 2023) that allows you to skip capital gains tax, Barlow explained.
“And they had to take less out of the account” to spend for the year, which preserves savings, he said. This is an “atypical scenario,” Barlow admitted, but demonstrates the potential benefits of tax diversification.
Starting in 2023, people with Medicare Part B may be able to save money on their premiums, as well as their annual deductible.
1. Investment diversification: spreading your investments across a variety of assets like stocks, bonds, cash, and certificates of deposit protects your money from wild market swings.
2. Tax, or balance sheet, diversification: using various types of accounts gives you the flexibility to spend money from different accounts to maximize tax savings when you retire.
What accounts should I use for tax diversification?
You should have money in each of three types of investment accounts:
Fully taxable accounts like brokerage accounts are funded with after-tax money, and taxes are paid annually on dividends, interest earnings, or capital gains if an asset is sold. They aren’t subject to required minimum distributions after age 73. Money withdrawn from these accounts is taxed as capital gains, which are generally at more favorable rates than ordinary income.
Tax-deferred accounts, like 401(k)s or IRAs, are funded with money you haven’t paid any tax on and grow tax-free until you withdraw the money. Withdrawals are taxed as ordinary income.
Tax-free accounts, like Roth IRAs, are funded with after-tax money so no taxes are imposed on earnings or withdrawals.
Note: You can contribute to a Roth IRA in 2023 only if your modified adjusted gross income is less than $153,000 for a single filer or $228,000 for joint filers. However, some companies offer Roth 401(k)s or you can use a so-called backdoor IRA.
There's no one size fits all tax diversification strategy but here are some guidelines:
Between ages 59-½ and 73, if you’ve stopped working or work part time and are old enough to withdraw from tax-deferred accounts without penalties but under the age to take required minimum distributions, consider gradually reducing your tax-deferred accounts.
Withdrawals are taxed as ordinary income, and without a large paycheck, you’ll likely be in a lower tax bracket and pay less tax.
Spend money you take out or convert it to a tax-free account like a Roth IRA. After five years, you can withdraw money from the Roth IRA tax and penalty-free anytime. Roth IRAs are not subject to required minimum distributions, which are taxed as ordinary income.
While working, contribute to your company’s 401(k) to at least get the company match if one’s offered and take the tax benefit.
If you’re under 35, consider contributing to a Roth IRA to take advantage of tax-free growth. Because your tax bracket is likely low, “the benefit of a tax deduction is far outweighed by tax-free growth,” Bruno said.
In your peak earnings years, generally between the mid-30s to 50s, contributing to a tax-deferred account for the immediate tax deduction might be better than the tax-free growth, she said.
Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.
