Why Your Retirement Needs Tax Diversification

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While people consider the task of preparing for retirement – mostly saving and properly investing for it – they may overlook an important consideration. Retirement planning needs to include tax diversification. This is especially important because more than a few people will be retiring in a higher tax bracket than they’re in right now. Here are…

While people consider the task of preparing for retirement – mostly saving and properly investing for it – they may overlook an important consideration. Retirement planning needs to include tax diversification. This is especially important because more than a few people will be retiring in a higher tax bracket than they’re in right now. Here are some different ways you can diversify your retirement income.

Tax-Deferred Retirement Plans

tax deferred investments
Tax deferred accounts let you wait until retirement to pay taxes.

Most people are familiar with traditional tax-deferred retirement vehicles, such as IRAs and 401(k)s. But the operative term in all of these plans is tax-deferred. It’s important to recognize that tax-deferred does not mean tax free. Since you are able to deduct your contribution to these plans from your income for tax purposes, you will pay taxes on those same dollars once you begin withdrawing them from your plans.

What really happens with tax-deferred retirement plans is income shifting. That is, you’re moving current income into the future. And as you do, you’re also transferring your tax liability along with it.

While these plans are the foundation of retirement planning, it’s important to consider income tax consequences. At the time you reach retirement age, you be collecting Social Security and probably at least some form of earned income or non-retirement investment income. When you add annual withdrawals from your tax-deferred plans to this income, you could be in a higher tax bracket than you ever imagined.

This will be even more significant since you’ll probably have fewer tax deductions, such as your personal exemptions for dependents, and even the inability to itemize deductions, particularly if your mortgage is paid off.

All of this is what we might refer to as a “good problem” – a high tax liability as a result of generous income. But there are a few things you can do about it too, but you’ll have to start working on it now.

Roth IRAs and Non-Deductible IRAs

IRAs offer you two possibilities for income tax diversification.

Roth IRAs. The best thing about Roth IRAs is that they offer you the ability to escape income taxes completely in your retirement years. Since your contributions are not tax-deductible, they will not be taxable upon withdrawal. And any earnings that you have in your Roth can be withdrawn free from income taxes as long as you’re at least 59 ½ at the time you begin accessing the plan, and have participated in it for a minimum five years. If you can qualify for Roth IRA, you should start one as soon as possible.

Non-deductible IRAs. Because of income limits, not everyone can participate in the Roth IRA program. If not, you should consider a traditional IRA, even and especially if the contributions are not tax-deductible. Any contributions that are not deductible for income tax purposes at the time they are made, can be withdrawn free from income tax later on. This will give you at least one source of retirement savings that will not be subject to income tax. (Note: earnings on a traditional IRA are tax-deferred, even if the contributions aren’t tax deductible, which means there will be taxes on the withdrawal of those earnings.)

Advanced tip: You can also use a non-deductible IRA as a backdoor way to contribute to a Roth IRA. You can make the non-deductible contribution, then convert the non-deductible IRA into a Roth IRA with what is called a Roth IRA conversion. This can cause additional tax implications, depending on your situation. So be sure to read the current rules for Roth IRA conversions, or meet with a tax professional before taking this step.

Roth 401k Plan

Some employers offer a Roth 401k plan in addition to the traditional 401k plan. Contributing to a Roth 401k gives you another opportunity for tax diversification in your retirement years. They share some similarities to Roth IRAs, namely that you pay taxes on your income now, then your withdrawals in retirement are tax free. However, there are a few differences. For example, Roth 401k plans are subject to required minimum distributions starting at age 70½ and there is no option to take a penalty free withdrawal. Don’t let a few small differences stop you, though. You can always start a Roth 401k now, then roll it into a Roth IRA when you leave your job or retire.

Non-Retirement Savings

While tax-sheltered retirement plans are specifically tailored for retirement and offer tax advantages for doing so, the fact is that any investment you have can be a retirement asset – even if it is not tax-deferred.

At least some of your long-term investments should be held outside of retirement plans, at least for income tax purposes. Since these investments are funded with after-tax income, and since you are required to pay tax on any investment earnings along the way, the funds are available for withdrawal free from any early withdrawal penalties or adverse tax consequences. The only thing you will need to worry about is capital gains tax.

A mix of withdrawals from both tax-deferred and non-deferred investments is an excellent way to minimize income taxes once you reach retirement.

Pension Plans

Pensions are normally taxed as regular income by the government, however, many states do not tax income from pensions. You will likely still owe federal taxes, but reducing state income tax can help your retirement income go a lot further.

Personal Residence

One of the best forms of tax planning for retirement – even if it isn’t intentional – is your personal residence. As you pay down and payoff the mortgage on your home, and the property rises in value over time, it will  most likely be your largest single asset. If need be, you can sell it to provide you with additional investment capital, and there is a major tax advantage in doing so.

Under IRS regulations, a single person can exempt $250,000 of gain on a primary residence from income taxes. A married couple could shield $500,000. This means that if you purchase a home for $100,000, and sell it 30 years later for $600,000, the $500,000 gain will not be subject to income taxes if you are a married couple.

Any amount of gain that exceeds the exemption amount will be considered long-term capital gains, and taxed at the capital gains tax rate of not more than 20% (compared to as much as 39.6% for ordinary income).

That will represent more money that you will have available that will not be subject to income tax when you retire.

Other Business Assets

There are various business assets that you can acquire and sell prior to retirement as long-term capital gains, and therefore taxed at the lower 20% rate. This can include various business assets, an entire business, or investment real estate.

Much like a primary residence, these are assets that tend to grow in value over time. As long as you hold them for more than one year, you will be able to sell them as long-term capital assets, which will shield the gains from much higher ordinary income tax rates.

So when you’re planning for your retirement, consider potential income tax liability, and spread your investment activities beyond the typical tax-deferred retirement plans.

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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  1. Roger @The Chicago Financial Planner says

    The concept of tax diversification is very important in retirement and in my opinion will be even more important down the road. This type of planning is important for all but especially younger retirement savers.

  2. Kevin Mercadante says

    Hi Roger – I have to agree. With budget deficits all over the place, and increased costs for healthcare, we should fully expect the tax grab to get more intense. Some smart moves now would help to head it off, or at least to minimize the damage.

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