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What Tax Diversification Means To Your Retirement

No doubt many of us have encountered the familiar dilemma of navigating the pros and cons between tax-deferred or Roth accounts when saving for retirement. While discussion of the topic is pervasive, much of the information out there fails to explicitly explain why the choice is an important one. Further, many oversimplify the decision along the narrow lines of whether or not one believes he/she will be in a higher or lower tax bracket in retirement than he/she is now.

This framing inherently fails to acknowledge the complexities and the planning that a successful draw-down strategy should incorporate, as well as the small fact that it is (currently) impossible to predict the future. Behind all the talk of Roth vs. tax-deferred is the fundamental concept of tax diversification—a broad term that is central to positioning one’s wealth in order to most tax efficiently tap assets in retirement.

When we think about the most likely (and widely used) sources of retirement income, it is useful to understand their differences along the lines of tax treatment in order to grasp the importance of tax diversification. Here’s a chart summarizing this information.

tax-chart
tax-chart

Keeping the above basic assumptions in mind, let’s look at three different draw-down/distribution strategies to demonstrate why tax diversification is important.

Let’s consider a married retiree at the age of 65, with both a tax-deferred IRA containing $1 million and a Roth IRA with $1 million. She has decided that she will need to draw approximately $80k per year from her retirement accounts, and she and her partner have no other income at this time.  For simplicity’s sake, let’s also imagine that she’ll be taking the standard deduction on her tax return.

Scenario 1: Take the annual required $80kfrom her tax-deferred IRA.

scenario1_tax-diversification
scenario1_tax-diversification

She would withdraw $80,000, as well as an additional $7,968 to service her income tax obligation, for a total withdrawal of $87,968. Her effective tax rate would approximately be 10% ($7968/$87,968), and her marginal tax rate would be 15%.

Scenario 2: Take the annual required $80k from her Roth IRA

scenario-2_tax-diversification
scenario-2_tax-diversification

Because all the funds in the Roth account are after-tax assets, our retiree would pay no taxes on her distribution, with her effective tax rates being 0%.

Scenario 3: Take a portion of the required annual income from both the tax-deferred and the Roth IRAs.

scenario-3_tax-diversification
scenario-3_tax-diversification

The retiree would take $20,500 from her tax-deferred IRA, and the additional $59,500 from her Roth IRA. She would pay $0 in taxes with an effective tax rate of 0%.

While scenarios 2 and 3 have equal tax consequences, scenario 3 may be more advantageous because it not only eliminates a tax bill, but also preserves more funds in the Roth account by drawing a portion from the tax-deferred account, thereby lowering future Required Minimum Distributions.

rmd-graphic
rmd-graphic

These are fairly simplified examples, but they do serve a purpose in demonstrating why tax diversification is important and why the same amount of annual retirement income can have quite different tax consequences depending on which type of account we draw from. When we add required minimum distributions, social security, and taxable investment accounts to the mix, an extra level of complexity is added.

5 Key Take-Aways/Strategies

  1. Roth funds can give you an enormous amount of flexibility in your drawdown strategy.
  2. RMDs can inadvertently keep you in a high tax bracket if you have high balances in your Traditional IRAs.
  3. Consider easing into retirement through a year or two of part-time/declining workload, as well as deferring Social Security to give you some lower earning years in which to convert tax-deferred assets into Roth funds (Roth conversions).
  4. Use proper (coordinated) asset allocation to optimize the value of retirement accounts for tax efficiency and tax diversification strategy.
  5. Taxable assets have a purpose in funding retirement-- like helping to keep you in a lower income tax bracket (capital gains vs. earned income), but should generally be funded after tax-sheltered accounts when saving for retirement.

-Emily Taken-Vertz

For general information purposes only and should not be considered an individualized recommendation or personalized investment advice.  This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Brouwer & Janachowski recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.  All expressions of opinion are subject to change without notice.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.