By Ted Stricker, CFP®
“Diversification” is a well-known term and strategy when it comes to investing, but you may be less acquainted with it when it comes to tax planning. The two ideas are related, however; tax diversification is merely the method of organizing and strategizing your investments among accounts with different tax treatment to minimize the tax impact and tax liability in the aggregate.
Our team at Bernath + Rosenberg believes tax diversification in retirement is critical, since retirement usually means significant withdrawals from accounts to sustain retirement lifestyles will occur and likely create taxable income. Minimizing the resulting tax liability should be a first priority. After all, “it’s not what you earn, it’s what you keep” applies not only to the accumulation years leading up to retirement, but also the years in retirement as well.
Let’s explore what tax diversification is and how the concept might be used in retirement income and tax planning.
What Is Tax Diversification?
Tax diversification is a financial strategy that seeks to distribute investment holdings within various types of accounts with differing tax treatment, effectively positioning such holdings to achieve maximum tax efficiency and minimize tax liability over the long term. This concept may also reduce risk, increase withdrawal choices, and increase overall retirement resource longevity, while maintaining flexibility for income, especially in retirement.
At a basic level, we can break down the types of accounts into three categories (for simplicity, accounts held in a trust with its own tax ID number are not included):
- Tax-deferred: Contributions to these accounts (except annuities) often receive an up-front tax deduction, and earnings are tax-deferred, but eventually taxes will need to be paid on withdrawals. These accounts may also have required minimum distribution (RMD) rules where taxable withdrawals must occur after a certain age. These include employer-sponsored 401(k) and 403(b) accounts and traditional IRA and IRA rollover accounts. Deferred annuities are in this category but usually do not have RMDs.
- Tax-free: Contributions to these accounts have already been taxed and further earnings are tax-free as well. Excluding inherited Roth IRAs, these accounts do not have minimum distribution requirements and include Roth IRAs and Roth 401(k) accounts, as well as health savings accounts (HSAs).
- Taxable accounts: There are few tax deductions or tax deferral with such accounts; earnings and realized gains are taxable each year. No required distributions and full flexibility are advantages here. Brokerage investment accounts, bank savings accounts, bank CDs, and money market accounts fall into this category.
Tax Diversification in Retirement: First Step = Understanding
The initial task in tax diversification is understanding how the underlying retirement and investment accounts holdings will be taxed. From there, during retirement, an income and withdrawal strategy may be crafted that satisfies income needs with minimal tax liability.
Withdrawals from tax-deferred accounts, such as 401(k)s, traditional IRAs, and deferred annuities, are taxed at ordinary income rates; the same rates as earned income and the taxable portion of your Social Security income.
On the other hand, Roth IRA and Roth 401(k) have zero tax liability upon withdrawal; these accounts can often provide “filler income” to fulfill the balance of income needs without further tax liability or to avoid ascending to higher tax brackets. Roth IRA conversions during low-income years may be a smart strategy to consider for the future.
Taxable accounts are the in-between type. Withdrawals may trigger tax liability if holdings are sold to raise cash for the distribution, but the tax treatment may be at lower capital gains rates. At the same time, annual dividends, interest, and interim capital gains (e.g., mutual fund pass-through gains) are taxed at levels that may be lower than the taxpayer’s ordinary income bracket.
Next Step: Asset Location
Once you understand how different accounts and withdrawals are taxed, the next step is to strategically place your investments to enhance tax efficiency (also known as asset location). This involves selecting the most appropriate accounts for each type of investment to minimize your overall tax burden. As an example of what not to do, it may be best not to hold a municipal investment or tax-managed mutual fund within a tax-deferred account.
Instead, tax-efficient investments, like tax-managed funds and exchange-traded funds (ETFs), typically generate fewer capital gains, which can lower your tax burden, so holding these in taxable brokerage accounts may be better. High-income investments or active-trading strategies (that might generate higher-taxed short-term gains) might be best positioned within tax-sheltered IRA accounts.
Strategize Withdrawals and Distributions
Once asset location has been achieved, the planning of distributions for income needs can be tackled. This will need to be coordinated with other sources of taxable income, including part-time work or installment income (such as a buyout from a business sale) in retirement, Social Security income benefits, pension income, and any RMDs.
Along with considering these other sources of income, the tax treatment of various distribution choices should also be coordinated with charitable intentions (and deductibility offsets), present and future legacy gifting to family members, and other estate planning or financial objectives.
Distribution decisions will likely need to be made with regard to each account’s portfolio management as well. Coordinating income and distribution objectives with portfolio management is essential for achieving tax efficiency, preserving retirement assets, and sustaining your lifestyle and legacy goals. This coordination relies on methods such as rebalancing, tax-loss harvesting, timing investment strategies, and adapting to changing market conditions.
If this sounds quite complex and comprehensive, you’re right! This is why we believe that having both tax experts and wealth managers working together to reach all these objectives effectively is truly the sensible and correct approach to retirement income planning.
Want to Learn More About Tax Diversification? Talk With Us.
Tax diversification, coordinating your retirement income needs, and multi-year tax planning are all core services at Bernath + Rosenberg. We’re here to help you!
Our experienced team of Certified Public Accountants and CERTIFIED FINANCIAL PLANNER® professionals stays current with the latest in tax laws and financial planning strategies to help you pursue a rewarding and comfortable retirement, save on tax liability, and plan for your family’s future, according to your unique and special objectives.
To get started and make the most of your hard work, schedule a meeting by calling (212) 221-1140 or email tstricker@brwealth.com.
About Ted
Ted Stricker is a partner and financial advisor at Bernath + Rosenberg, a full-service accounting, tax, and wealth management firm with offices in Monsey, NY, Lakewood, NJ, Cedarhurst, NY, and Miami Beach, FL. The firm demonstrates a personalized approach to custom-tailored solutions and an unwavering commitment to client service. With over 26 years of experience in the financial services industry, Ted manages the firm’s wealth management team, and specializes in designing financial plans for business owners and affluent families. Since joining the team in 2015, he provides practical and sound advice, combining innovative approaches and solutions that reflect clients’ personality, lifestyle, and goals.
For the ninth year in a row, Bernath + Rosenberg has been named as one of the leading CPA firms in financial planning by Accounting Today, a publication that receives hundreds of submissions each year and features the Top 150 Firms in the nation. Ted is a CERTIFIED FINANCIAL PLANNER® practitioner and is a member of the Financial Planning Association. To learn more about Ted, connect with him on LinkedIn.
Professionals associated with Bernath & Rosenberg P.C. may be either (1) registered representatives with, and securities and advisory services offered through LPL Financial, Member FINRA/SIPC, a registered investment advisor; or (2) solely tax professionals of Bernath & Rosenberg P.C., and not affiliated with LPL Financial. Tax/accounting/CPA-related services offered through Bernath & Rosenberg P.C. is a separate legal entity and not affiliated with LPL Financial. LPL Financial does not offer tax advice or tax/accounting/CPA-related services.
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