Musicians always hit a familiar chord with fans when they sing about life’s mysteries, like love, loss, growing up, looking back—and taxes. The Beatles and Johnny Cash, among many other familiar artists, made hits about taxes that still find their way on to playlists because everyone can relate.
Aside from humming along to the music, what can you do about taxes? There are strategies you can put to work that could reduce what you pay now and in retirement. Let’s start with the basics.
Manage your withholding
Being strategic about taxes begins with your paycheck. Three out of four taxpayers (73.2%) received a refund in 2019, according to
Understand how tax brackets work
For proof that taxes can be complicated, just look at the tax brackets in the current federal income tax system. There are
It’s easy to sing off-key about taxes. But the truth is, the top federal tax rate today of 37% is nowhere near the 70% range in the 1970s when Johnny Cash was crooning on the topic. Will taxes ever go back up like that? No one knows what will happen next year, much less in the decade you retire. But mindful planning can help you minimize what you owe over time.
Take advantage of 3 diversification strategies
Time diversification, investment diversification and income tax diversification are three strategies you can use as you juggle multiple goals over time. Whether your retirement is decades from now or so close you feel it with every stock market swoon, these strategies can help guide you.
1. Time diversification
Time diversification plays a role throughout your life as you set out to achieve various short- and long-term goals—buying a home, traveling the world, sending your kids to college, retiring early. As you choose the most tax-efficient type of investment account to help you reach your goals, when and how you plan to use the money will be factors.
Early in your working years, time is on your side, and increasing the amount you save every year may be a financial priority. Generally, the more you contribute to your qualified retirement plan each year, the less you owe in taxes now.
2. Investment diversification
Investment diversification can help you minimize the taxes you will eventually pay in retirement by allocating your assets across a variety of asset classes. Diversification alone does not assure a profit nor can it protect against losses in a volatile or declining market, but it can be an effective way to minimize market risk and protect you from inflation.
Depending on your age, you might be more interested in choosing investments that align with your goals and
3. Income tax diversification
Income tax diversification involves investing in a variety of tax-advantaged accounts to help minimize how you’re taxed on those accounts now and in the future. This concept advocates that you should diversify your holdings into three different buckets: some taxable money, some tax-deferred money and some non-taxable money. We call these buckets "tax now," ‘"tax later" and "tax never" (which leads us into our next concept).
Tax now, tax later, tax never
Income tax diversification is about saving more money in the long term. It involves the process of investing in a variety of tax-advantaged accounts … commonly referred to as buckets. Essentially, these three income tax buckets show how different types of investments are taxed at different times.
1. Tax now
"Tax now" accounts that are taxed up front are better suited for current or short-term needs.
- Checking accounts2
- Certificates of deposit (CDs)2
- Mutual funds2
- U.S. Treasuries2,3
2. Tax later
"Tax later" (tax-deferred) accounts are generally used for long-term needs like retirement. Tax deferral during your working years means that you can reduce your taxable income by the amount you contribute to qualified retirement accounts every year.
- Qualified retirement plans like IRAs, 401(k), 403(b) and other pension plan assets4,5,6
- Variable and fixed annuities4,7
- U.S. Savings Bonds8
3. Tax never
Tax-free assets in the "tax never" bucket generally offer preferential income-tax treatment on the accumulated value and its distribution.
- Roth IRAs and Roth 401(k)s6,9
- Municipal bonds10
- Life insurance11
Assuming you’ll pay fewer taxes in retirement could be a mistake since you may have fewer deductions at that time, such as no mortgage interest or children to claim as dependents. And, you will no longer be making tax-deferred contributions to retirement accounts. Being strategic now could help you reduce or even eliminate some tax consequences in later years.
Give yourself a tax-efficiency checkup