Tax diversification tips can help you position your assets more efficiently.
You may be familiar with the old adage: don’t put all your eggs in one basket.
The phrase is often used in reference to your retirement savings strategy, when you’re encouraged to diversify your investments across a variety of asset classes. While this approach can’t protect against losses in a declining market, it can be a good way to minimize risk.
The basket adage also is helpful when it comes to thinking about income taxes and your retirement savings.
“All your money is taxed in one way or another; that’s usually understood,” says Nathan Smith, Thrivent wealth advisor in Overland Park, Kansas. “But how and where you save it can impact when it will be taxed. Tax benefits you take early in life could impact your retirement strategy, if you don’t plan.”
Whether you’re just starting out, planning for retirement or already in retirement, there are several things you should know about income tax diversification*.
Tax benefits you take early in life could impact your retirement strategy, if you don’t plan.
The basics of income tax diversification
At its core, income tax diversification means that your investments are in a mix of accounts with different tax treatments—taxable, tax-deferred or tax-free. You also may hear it described as tax now (or always), tax later and tax never.
Creating a strategy can help you position the money you’re saving—or already have saved—to be more income-tax-efficient and potentially increase your total spendable income when you need it most.
This basket holds the savings accounts where any potential interest, dividends and gains that you earn are taxed immediately. Typically, these are the accounts like checking, savings, certificates of deposit and mutual funds.1 The accounts are more liquid, meaning you can take out the funds when you need them, says Ron Lutes, advanced market specialist at Thrivent. But you must claim any gains annually on your taxes as income.
“Everyone needs to have liquid money,” Lutes says. “Life happens—the car breaks down, a storm comes through, you become unemployed. This is your emergency savings fund. It also can be your short-term savings account if you’re saving to buy a house or a new car.”
Money in many of these accounts won’t fluctuate with the market, Lutes says, but for all of them, the money will be there when you need it.
Bottom line: Gains on this money are taxed annually, but the contributions and potential gains are readily available for a rainy day.
These accounts, which include 401(k)s,2,3,4 403(b)s2,3,4 and traditional IRAs,2,3,4 are funded with pre-tax dollars and grow tax deferred. This means you pay the income tax on both your contributions and any potential gains when you withdraw the funds8. Fixed and variable annuities2,4,7 are another option and are funded with after-tax dollars. These dollars grow tax deferred and you pay income tax on the gain when you withdraw the funds. There are rules and restrictions with these accounts, which may include premature distribution penalties.
“For many Americans, the majority of savings is in the tax-later basket,” Lutes says. “It’s the easiest place for people to save.”
As you get closer to retirement, you may want to take a closer look at this bucket to determine how much taxable money you’ll have once in retirement and potentially take some steps to change it. The more taxable income you have in retirement, he says, the greater the taxation of any Social Security benefits you’ll receive.
Bottom line: In this basket, contributions and any potential gains are tax deferred, and the assets are generally earmarked for longer-term needs, like retirement and college funding.
“The gains you may get on accounts in this basket may not get taxed,” Smith says. “You won’t get taxed on them annually, and when you take the money out, you won’t get taxed either.”
Roth IRAs5 and Roth 401(k)s,5 municipal bonds6 and life insurance with cash value are the most common accounts in the tax-never basket.
For most people, the Roth IRA is the most obvious. Contributions are made with after-tax dollars and would not be taxed twice. And if you follow distribution rules from the Roth, earnings also would not be taxed, Smith says. However, you must have earned income to contribute to a Roth, and there are income limitations.
Bottom line:Funded with after-tax dollars, these assets generally offer preferential income-tax treatment on the accumulated value and its distribution.
It’s never too early or too late to begin considering your tax diversification options.
“It’s never too early or too late to begin considering your tax diversification options,” says Karen Birr, manager in Advanced and Retirement Consulting at Thrivent.
Traditional or Roth?
No matter your age, if you’ve got the option of a traditional or Roth 401(k) from your employer, or you’re thinking about starting either a traditional or Roth IRA, consider whether you’d benefit from the tax deduction now (tax-deferred) or the tax benefit later (tax never). One thing to remember: your employer’s contribution to your Roth 401(k) is pretaxed, so that portion will be taxed when withdrawn.
“Based on current tax laws, the 30 to 40 years of potential growth that could come out of a Roth 401(k) or Roth IRA may be advantageous— you’ve already paid taxes on your contributions, and your earnings are tax free when it’s a “qualified distribution,” Birr says.
Extra dollars in a tax now account
Annuities are an option for those who have money in tax-now accounts that they don’t need. “You may get a better rate of return and you won’t get taxed every year on any earnings,” Smith says. An annuity would move the assets from the tax-now to the tax-later basket.
If you own an individual stock outside of a traditional retirement account, it is taxed when you sell.
If you’re planning to
Your Social Security is taxed based on your income, Lutes says, so the more taxable income you have in retirement, the greater the taxation on your Social Security benefits. If you’re planning to do a Roth conversion, for example, plan for it before you start drawing Social Security.
The SECURE Act that went into effect on January 1, 2020, changed the age for required minimum distributions (RMD) from traditional IRAs and employer tax-deferred accounts from age 70½ to 72. “This change enables our older clients to have more years to accumulate assets and gives them more time to facilitate Roth conversions, moving more money from the tax-later into the tax-never bucket,” Birr says.
The considerations above reflect income taxes to the owner, and depending on your situation, you also may want to consider the impact on your beneficiaries. When leaving assets to your children, there are options to avoid leaving them taxable dollars, such as 401(k)s and traditional IRAs. Consider funding life insurance for the children, which is not taxable to beneficiaries. And leave the taxable dollars (such as your retirement accounts) to your favorite charity or donor-advised fund, since these are non-taxable entities. In addition, your estate could receive a charitable deduction. (Donors should consult with their attorney or tax professional.)
“Everyone’s situation is different,” Birr says. “The best strategy is to talk with your financial advisor, who will take into account your needs, wants and objectives, and the resources you have to meet your objectives. Together, you’ll consider your risk tolerance and develop a strategy that makes sure your investments are in the appropriate types of accounts to be as efficient as possible and enabling you to live a life of meaning and gratitude.”
As you consider your options for tax-efficient decisions, consult with your