retirement mistakes

Tax Diversification Strategies

When it comes to saving for retirement, it’s important to not let taxes diminish your savings more than necessary. Learn how to help minimize taxes through tax diversification with Johnson Wealth and Income Management.

Taxes can be overwhelming in retirement, often eating up a good chunk of income that you are living on. Tax diversification, as it relates to investing, refers to the strategic allocation of assets among multiple investment accounts with varying taxation. Knowing these tips about tax diversification may help you counter the ever-changing tax environment affecting your investment accounts, and provide flexibility in your retirement years.

But first, let’s get back to basics.

Tax Diversification Explained

Tax diversification is a strategy that considers the various tax treatment of the investment accounts you will eventually use for income after you stop working. Coupled with a tax-efficient withdrawal strategy, tax diversification could help your assets last longer in retirement. Types of accounts you can use to accomplish this include:

  • Traditional 401(k), 403(b) or IRA: You get a tax deduction when you contribute but have to pay taxes when you withdraw the money in retirement. The government requires you to take required minimum distributions at age 72 (or age 70.5 for those born before July 1, 1949).
  • Roth 401(k), 403(b) or IRA: Although you don’t get a tax deduction when you contribute, funds grow tax-free, qualified withdrawals are tax-free and there are no required minimum distributions.
  • Taxable savings or brokerage account: You pay tax on any dividends or interest annually and on capital gains when you sell.

By helping to ensure that an individual’s retirement portfolio includes tax-free assets, the strategy of tax diversification can be used to help build wealth now and in the future. In some situations it may make sense for individuals to save for retirement in taxable accounts instead of in retirement accounts. Benefits of saving for retirement in a taxable account may include helping those who can’t save in employer accounts or want to save beyond IRS contribution limits, plus taxable accounts have more accessibility to assets than retirement accounts. However, when saving in taxable accounts, be mindful of the fees and how interest, dividends, and capital gains are taxed.

With this information in mind, here are three strategies to help achieve tax diversification, help to maximize your retirement income and help minimize your future tax obligations.

1. Contribute to a Roth IRA or 401(k)

If you’ve got earned income and are within government limits for Roth IRA contributions, one of the biggest financial moves for retirement is to make Roth IRA contributions.

A Roth plan offers an opportunity to create a tax-free income source in retirement with its tax-free investment growth and tax-free withdrawals. To qualify, you would need to have held your Roth for five years or longer and you’ve reached age 59 ½ at the time of withdrawals. Though Roth IRAs and Roth 401(k)s are similar, the differences lie in their annual contribution limits, eligibility criteria, and whether or not you’ll need to take required minimum distributions (RMDs).1 Work with us to weigh the pros and cons of each and we’ll come up with what’s best for your situation.

2. Diversify Your Accounts

Investing in accounts with different tax treatments can provide you with flexibility (and potentially higher after-tax income) in retirement. Using a combination of investment account types lets you mix and match income sources in retirement to help minimize your taxes. Different investment account types offer different tax treatments:

  • Traditional IRAs offer tax-deferred growth potential
  • Roth IRAs offer the potential for growth that won’t be federally taxed if account owners meet requirements for qualified distributions (state taxes may apply)
  • Brokerage accounts offer taxable growth potential

Spreading your contributions among different account types may help you reduce your taxes in retirement, whether your future tax rates will be higher or lower than they are now, if you take steps ahead of time to establish different account types for tax diversification.

3. Choose Tax-Efficient Investments

Taxes shouldn’t be the primary driver of your investment strategy—but it makes sense to take advantage of opportunities to manage, defer, and help reduce taxes.

Depending on your situation, consider investing in municipal bonds, which is always federally tax-free (and even state and local tax-free if you buy municipal bonds in your resident state). Further tax-smart investment choices could include tax-managed mutual funds, where the fund managers work purposefully for tax-efficiency. You can also choose to invest in index funds and exchange-traded funds (ETFs) that passively track a target index. Because the securities in the index funds are not traded as frequently as the actively managed mutual funds, they usually generate lower short-term capital gains distributions.

You can’t take full advantage of tax-efficient investments unless you’re also holding them in accounts matched to the appropriate tax treatment. This way, you can truly realize the full potential of the tax benefits you’re seeking – without accidentally increasing your tax liability.

Further Ways to Help Minimize Taxes

Whatever strategies you use, remember that tax-efficiency isn’t the only consideration for your investment decisions. You also need to think about how each investment can help you pursue your diversification, liquidity and overall investment goals — at a level of risk you are comfortable with. You may also want to consider other actions, including:

  • Tax-loss harvesting
  • Portfolio rebalancing and reducing over-concentrated positions
  • Increasing contributions to traditional or Roth IRAs and employer-provided retirement plans
  • Using tax-advantaged education savings vehicles, such as 529 Education Savings Plans
  • Seeking professional help from an experienced financial advisor

Investing tax-efficiently doesn’t have to be complicated, but it does take some planning. By being strategic about the potential opportunities to help manage, defer, and reduce taxes, you could potentially improve your bottom line.

Do you have further questions on tax diversification strategies? Whether your retirement is decades away or just around the corner, the retirement income advisors at Johnson Wealth and Income Management can provide you guidance every step of the way, and help you learn new ways to diversify your taxes in retirement.

Contact us here today to learn more. 

All written content on this site is for informational purposes only. Opinions expressed herein are solely those of Johnson Wealth & Income Management and our editorial staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. Investing involves risk. There is always the potential of losing money when you invest in securities. Asset allocation, diversification and rebalancing do not ensure a profit or help protect against loss in declining markets. All information and ideas should be discussed in detail with your individual advisor prior to implementation. The presence of this website, and the material contained within, shall in no way be construed or interpreted as a solicitation or recommendation for the purchase or sale of any security or investment strategy. In addition, the presence of this website should not be interpreted as a solicitation for Investment Advisory Services to any residents of states where otherwise legally permitted to conduct business. Fee-based financial planning and Investment Advisory Services are offered by Sound Income Strategies, LLC, an SEC Registered Investment Advisory firm. Johnson Wealth & Income Management and Sound Income Strategies LLC are not associated entities. Johnson Wealth & Income Management is a franchisee of the Retirement Income Store. The Retirement Income Store and Sound Income Strategies LLC are associated entities. © 2021 Sound Income Strategies.

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