Tax diversification can help you save. Here's what to consider with your retirement funds.
It’s tax season, and people who are busy making last-minute contributions to retirement funds to take advantage of tax benefits this year might be forgetting to consider where they’re putting money.
Different types of retirement accounts offer different tax advantages in retirement. How and when you withdraw money from various accounts can determine how much you pay in taxes, so diversifying the types of accounts is just as important as diversifying the types of investments you make.
"Every dollar you lose to taxes is one less dollar in your pocket,” said Maria Bruno, Vanguard’s head of U.S. wealth planning research. “Holding different account types helps manage uncertainty around future tax rates because we don’t know in 20 to 30 years, what the tax regime will be or what your personal tax rate might look like.”
Know this: Are you ready to file your taxes? Here's everything you need to know to file taxes in 2023.
Tax avoidance: How do rich people avoid taxes? Wealthy Americans skirt $160 billion a year in tax payment
Retirement and recession: Preserving your 401(k) during a recession
How does tax diversification help me save?
Jeremiah Barlow, Mercer Advisors’ head of family wealth services, had a client who retired, didn’t yet have to take required minimum distributions or social security, and paid zero taxes on $100,000 from a taxable account.
The client stopped working, and the couple’s income fell sharply, allowing the client to take $100,000 from a taxable account and take some deductions to push income below the threshold ($44,625 for individuals and $89,250 for joint filers in 2023) that allows you to skip capital gains tax, Barlow explained.
“And they had to take less out of the account” to spend for the year, which preserves savings, he said. This is an “atypical scenario,” Barlow admitted, but demonstrates the potential benefits of tax diversification.
Help: From taxes to retirement: Everything to know about the evolving role of financial advisers
Protection: 3 completely legal ways to shield your retirement savings from the IRS
How should I diversify my retirement portfolio?
Two types of diversification people need to consider are:
Tax or balance sheet diversification.
1. Investment diversification: spreading your investments across a variety of assets like stocks, bonds, cash, and certificates of deposit protects your money from wild market swings.
2. Tax, or balance sheet, diversification: using various types of accounts gives you the flexibility to spend money from different accounts to maximize tax savings when you retire.
Tidying up: Near retirement? Here's how to clean up your investment portfolio.
More taxes: Is Social Security income taxable by the IRS? Here's what you might owe on your benefits
What accounts should I use for tax diversification?
You should have money in each of three types of investment accounts:
Fully taxable accounts like brokerage accounts are funded with after-tax money, and taxes are paid annually on dividends, interest earnings, or capital gains if an asset is sold. They aren’t subject to required minimum distributions after age 73. Money withdrawn from these accounts is taxed as capital gains, which are generally at more favorable rates than ordinary income.
Tax-deferred accounts, like 401(k)s or IRAs, are funded with money you haven’t paid any tax on and grow tax-free until you withdraw the money. Withdrawals are taxed as ordinary income.
Tax-free accounts, like Roth IRAs, are funded with after-tax money so no taxes are imposed on earnings or withdrawals.
Note: You can contribute to a Roth IRA in 2023 only if your modified adjusted gross income is less than $153,000 for a single filer or $228,000 for joint filers. However, some companies offer Roth 401(k)s or you can use a so-called backdoor IRA.
Lowering tax bills: Wondering how to avoid taxes? Strategies used by super rich Americans you can use, too
Takes money to save money: How do rich people avoid taxes? Wealthy Americans skirt $160 billion a year in tax payment
Sometimes later is better: How long should you wait before filing taxes? Surprise! Later can sometimes be better
What are some tax diversification strategies?
There's no one size fits all tax diversification strategy but here are some guidelines:
Between ages 59-½ and 73, if you’ve stopped working or work part time and are old enough to withdraw from tax-deferred accounts without penalties but under the age to take required minimum distributions, consider gradually reducing your tax-deferred accounts.
Withdrawals are taxed as ordinary income, and without a large paycheck, you’ll likely be in a lower tax bracket and pay less tax.
Spend money you take out or convert it to a tax-free account like a Roth IRA. After five years, you can withdraw money from the Roth IRA tax and penalty-free anytime. Roth IRAs are not subject to required minimum distributions, which are taxed as ordinary income.
While working, contribute to your company’s 401(k) to at least get the company match if one’s offered and take the tax benefit.
If you’re under 35, consider contributing to a Roth IRA to take advantage of tax-free growth. Because your tax bracket is likely low, “the benefit of a tax deduction is far outweighed by tax-free growth,” Bruno said.
In your peak earnings years, generally between the mid-30s to 50s, contributing to a tax-deferred account for the immediate tax deduction might be better than the tax-free growth, she said.
Sophisticated tactics: What's an FSA, HSA, 529? How they work and how to use them to cut taxes, build wealth.
Hold off: Don't rush to start collecting Social Security retirement benefits at 62. Here's why.
Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at mjlee@usatoday.com and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.
More of your 2022 tax season questions answered
Tax season 2023 officially started: Here are key deadlines to keep in mind
1099, W-4, W-2, W-9, 1040: What are these forms used for when filing your taxes?
What are the 2022 US federal tax brackets? What are the new 2023 tax brackets? Answers here
2023 tax season guide for new parents: What to know about the Child Tax Credit, EITC and more
IRS may owe you from 2020 taxes. Here's why and what you need to do to find out if you're owed
What is OASDI tax on my paycheck? Here's why you and your employer pay this federal tax
Do you have to report crypto on taxes? Yes. Here's what you should know about form 8949
What is a 1098-E form? What you need to know about the student loan interest statement
Tax season 2023: What exactly is the mileage rate? There's more than one.
Is it better to pay someone to do your taxes or do them yourself? We'll help you decide.
What is income tax? What to know about how it works, different types and more
Is Social Security income taxable by the IRS? Here's what you might owe on your benefits
Companies can deduct full cost of business meals on 2022 tax returns
Who has to file a tax return: It's not necessary for everyone. Here are the rules.
What is capital gains tax in simple terms? A guide to 2023 rates, long-term vs. short-term
Best way to receive your 2023 tax refund? IRS says direct deposit. Here's how to do it.
What is FICA? How much you contribute to federal payroll taxes.
How much is the Child Tax Credit for 2023? Here's what you need to know about qualifying.
A 30% national sales tax? Abolishing the IRS? What the FairTax Act of 2023 would do.
The Inflation Reduction Act carves out an EV tax credit for 2023. Does Tesla qualify?
This article originally appeared on USA TODAY: How tax diversification can help you with retirement savings