Even novice investors have probably learned that diversification is an important tool for lowering risk. The main concept is to avoid concentrating assets in one position to prevent serious harm if an investment doesn’t work out. This includes diversifying among investment classes—and diversifying within the investment classes themselves—to reduce volatility.
Diversification is just as important to taxability as it is to investing. Simply put, tax diversification involves allocating investment assets across accounts and investment vehicles that are taxed in different ways—taxable, tax-deferred, and tax-free. We call these three types of accounts the New Three-Legged Stool™ of tax-efficient retirement planning. A sound tax diversification plan follows these three techniques:
1. Allocate assets by tax treatment.
To determine what type of investments to prioritize within your retirement planning, consider how the returns are taxed. The return from equity investments, for example, is generated in the form of dividends and capital gains, which are currently taxed at a maximum rate of 20%. Therefore, you’ll may want to keep a more significant percentage of equity holdings outside of your retirement accounts. Focus on keeping a larger percentage of fixed-income holdings in your retirement accounts, because the return is taxed as ordinary income.
2. Use tax-free bonds when holding fixed income in taxable accounts.
It is not always practical to hold all fixed income in retirement accounts and all equities in non-retirement accounts. When fixed income must be kept in non-retirement accounts, consider using municipal bonds, which are free from federal, and in some cases, state and local income taxes. For this reason, these bonds can be particularly advantageous for investors in the highest tax brackets. Tax-free bonds may even be attractive to those in lower tax brackets because their yields can be equal to, and in some cases exceed, the long-term average versus comparable taxable fixed income securities. When equities must be held in retirement accounts, consider investments with higher dividend payments, such as real estate investment trusts.
3. Find ways to fund a Roth regularly.
Consider investing in a Roth IRA or Roth 401(k) account based on your tax bracket each year. You may want to put only enough money in these traditional tax-deferred accounts to stay in the 12% tax bracket. This will require estimating taxable income to determine when you have reached the optimum tax deferral, and then saving additional funds in a Roth. Use this chart to check taxable income:
2021 Tax Brackets
Filing Joint Returns
($27,800 if both over 65)
|$0 to $9,950
|$0 to $19,900
|$9,951 to $40,525
|$19,901 to $81,050
|$40,526 to $86,375
|$81,051 to $172,750
|$86,376 to $164,925
|$172,751 to $329,850
|$164,926 to $209,425
|$329,851 to $418,850
|$209,426 to $523,600
|$418,851 to $628,300
|$523,601 or more
|$628,301 or more
You might consider converting part of your IRA to a Roth in a year when you know taxable income will be in the 12% tax bracket. For example, a couple filing jointly that estimates their taxable income will be $70,000 may consider converting $10,000 of their IRA to a Roth IRA
The financial press often advises retirees to take money from their accounts in the following order:
The reasoning is to preserve tax-deferred assets for as long as possible thus delaying payment of the Not without merit, this reasoning is to preserve tax-deferred assets for as long as possible, thus delaying tax payment. However, depending on an individual’s tax situation, this order may not be the best course of action. Consider the following chart:
|Consider the Following
|10% to 12% tax bracket
|Draw from tax-deferred accounts to maximum
taxable income for 12% bracket. This should help
reduce required minimum distributions at age 72.
|22% or higher tax bracket
|Use a combination of tax-free Roth distributions,
withdrawals from taxable accounts, and
withdrawals from tax-deferred accounts to
minimize taxable income.
|Significant capital gains in taxable
|Avoid withdrawals from tax-deferred accounts in
years gain is realized. Those with charitable goals
should gift appreciated assets instead of giving
|Wages or self-employment income
|Could trigger penalties on Social Security benefits
if under full retirement age. Consider suspending
benefits if income is significant.
Anyone with significant unrealized capital gains in taxable accounts may want to withdraw funds from tax-deferred accounts first. Appreciated assets will get a “stepped-up” cost basis when passed on to heirs, but tax-deferred accounts are fully taxable to heirs when the assets are withdrawn.
It is essential to actively estimate taxable income each year. You can adjust distributions from tax-deferred accounts to maximize the 12% tax bracket. When income is low, it may be best to take more from tax-deferred accounts, especially in the years before you reach age 72. Consider Roth conversions if you do not need the income for living expenses. This way, taxable income may be realized in a low tax year. The funds can be withdrawn tax-free from the Roth in a later year when the income is needed but your tax situation may not be as favorable.
Maintaining a lifestyle through 30 years of retirement is a challenging goal. Start with a sound investment strategy and be sure to prioritize tax efficiency when implementing the plan. A tax-efficient portfolio may require smaller distributions to maintain spendable income. This could make the difference between having plenty of money to pass on to heirs or coming up short.
- Diversifying investments can reduce investment risk. Diversifying savings using the New Three-Legged Stool™ strategy may minimize income taxes
- Waiting to withdraw retirement income from tax-deferred accounts is not necessarily the best strategy. Let your tax circumstances each year determine the order of withdrawing.
- Allocate assets by tax treatment to capitalize on the preferred tax status of long-term capital gains and qualified dividends.
Originally Posted: September 6, 2012