Most people have heard of diversification as a tool to lower risk (Don’t put all your eggs in one basket). The concept of diversification is to avoid concentrating your assets in one failing or under-performing investment that could cause serious harm.
Rodgers & Associates does not limit diversification to investing, we diversify to minimize taxes. Tax diversification involves allocating investments across accounts and investments that are taxed differently. We call our strategy the New Three-Legged Stool™ of tax-efficient retirement planning.
The three legs, explained.
Non-retirement investment accounts. Earnings in these accounts are generally taxable each year.
IRAs, 401(k)s, 403(b)s and most retirement accounts. Earnings in these accounts are generally deferred until later.
Roth IRAs, and Roth 401(k)s. Earnings in these accounts are generally tax-free when withdrawn.
The benefit of using this strategy is to reduce income taxes now and in the future.
It gives our clients flexible withdrawal options when they retire. This flexibility means they can adjust their source of income as the economy and tax laws change. Our advisers use this strategy for all phases of retirement.
During Phases 1, 2, and 3 they are calculating the optimal amount of income to defer or save after-tax. Actively estimating taxable income each year helps us determine how funds should be saved.
We continue tax projections in Phases 4 & 5 to determine the optimal way to withdraw funds from the three accounts.
A recent study1 found the most tax efficient withdrawal sequence could extend a retirement portfolio by seven and a half years longer than the least tax-efficient sequence.
The New Three-Legged Stool strategy is critical during the retirement journey for these three reasons:
Retire Right: The Critical Importance of Tax-Efficient Withdrawal Strategies to Portfolio Longevity, by William Reichenstein, Ph.D.