Even a novice investor has heard of the importance of diversification as a tool to lower risk. Diversifying among investment classes and diversifying within the investment classes themselves reduces volatility. The main concept is to avoid concentrating your assets in one position that could cause serious harm if it the investment doesn’t work out.
Diversification is just as important on the basis of taxability as it is to investing. Simply put, tax diversification involves allocating investment assets across accounts and investment vehicles that are taxed differently — taxable, tax deferred, and tax free. We call these three vehicles the New Three-Legged Stool™ of tax efficient retirement planning. A sound tax diversification plan includes the following techniques:
Allocate assets by tax treatment. The return from your equity investments is generated in the form of dividends and capital gains. Qualified dividends and long-term capital gains are currently taxed at maximum rate of 15%. Therefore a larger percentage of your equity holdings should be held outside of retirement accounts. A larger percentage of your fixed-income holdings should be kept in retirement accounts because the return is taxed as ordinary income. The return from equity investments is taxed at a maximum rate of 35% when it is held inside retirement accounts because it is considered a retirement distribution.
Use tax-free bonds when holding fixed income in taxable accounts. It is not always practical to hold all your 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. These bonds are particularly advantageous for investors in the highest tax brackets. Tax-free bonds may even be attractive to those in lower tax brackets now because their yields are equal to and in some cases above the long-term average versus comparable taxable fixed income securities. When equities must be held in retirement accounts use those with higher dividend payments such as real estate investment trusts.
Find ways to fund a Roth regularly. Consider funding a Roth IRA or Roth 401(k) account based on your tax bracket each year. Only put enough money in a traditional tax-deferred account to stay in the 15% tax bracket. This will require estimating your taxable income to determine when you have reached the optimum tax deferral and saving additional funds in a Roth. Use this chart to check your taxable income (click to see larger version):
You should consider converting part of your IRA to a Roth in a year when you know your taxable income will be in the 15% tax bracket. For example, a couple filing jointly that estimates their taxable income will be $60,000 should consider converting $10,000 of their IRA to a Roth IRA.
The financial press will often advise 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 tax. This reasoning is not without merit. However, depending on an individual’s tax situation, this order may not be the best course of action. Consider the following chart (click to see larger version):
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 very important to actively estimate taxable income each year. Distributions from tax-deferred accounts need to be adjusted to maximize the 15% tax bracket. You should take more from your tax-deferred accounts when income is low especially in the years before you are age 70 1/2. Consider Roth conversions if you don’t need the income for living expenses. This way the taxable income is realized in a low tax year. It 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 your lifestyle through a potential 30 years of retirement is a challenging goal. Start with a sound investment strategy and be sure to include tax-efficiency when implementing the plan. A tax-efficient portfolio requires smaller distributions to maintain your spendable income. This could make the difference between having plenty to pass on to your kids or running out of money.
- Diversifying your investments can reduce investment risk. Diversifying your savings using the New Three-Legged Stool™ strategy can reduce income taxes.
- Waiting to withdraw your retirement income from tax-deferred accounts is not necessarily the best strategy. Let your tax circumstances each year determine the order of withdraw.
- Allocate your assets by tax treatment to capitalize on the preferred tax status of long-term capital gains and qualified dividends.