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How To Benefit From Tax Diversification

Tax diversification is integral to a well-structured retirement plan. By holding assets in accounts with different tax treatments, such as traditional IRAs, Roth accounts and taxable investments, you can balance current and future tax benefits and gain flexibility to deal with unexpected circumstances.

The Three Types Of Investment Accounts

Many investors look down on taxable investment accounts because of the taxes they must pay each year on interest and dividends, as well as any gains resulting from sales. However, such accounts do offer several benefits. First, they are incredibly flexible. There is no restriction on the types of investments you can make on a taxable basis. And while both traditional and Roth-type retirement accounts are subject to annual contribution limits and to penalties for early withdrawal, there is no limit on contributions to a taxable account, and there are no penalties when you need access to the funds before your retirement.

Qualified dividends and capital gains are taxed at favorable rates in taxable accounts (zero for lower-income taxpayers, 15 percent for most taxpayers and 23.8 percent for high-income taxpayers). Also, investments sold at a loss can be used to reduce one’s tax liability. Since you can generally control when you sell an investment, you can control when you pay much of the tax liability that such accounts generate. The government again favors taxable investments upon the owner’s death. At that time, the cost basis is adjusted to the fair market value, and no capital gains tax is due if the estate immediately sells the holdings.

At first glance, tax-deferred retirement accounts, such as traditional 401(k)s, traditional IRAs and similar plans, may seem to be the most appealing savings options because, by reducing your current tax bills, they give you the biggest upfront benefit. Since none of the income is taxable until withdrawals are made, you may be able to save more overall as the benefits continue to compound.

Regrettably, savers can wind up paying for this upfront tax benefit later in life. Distributions from tax-deferred accounts are treated as ordinary income, even if the growth in the account was generated from investments that would have been taxed at lower capital gains rates in a taxable account. So you would effectively split any profits in tax-deferred accounts with the government. If an account grows by 10 percent per year and your tax rate stays the same, the eventual tax liability grows by that same 10 percent. In addition, the Internal Revenue Service generally requires retirees to begin taking certain minimum distributions from tax-deferred accounts at age 70 1/2, which can force you to generate taxable income at inopportune times. Furthermore, investments in a tax-deferred account do not receive a basis adjustment when the account holder dies. Beneficiaries will need to pay income tax when they withdraw assets from these accounts.

Tax-free or Roth accounts can be hard to beat. Although there is no immediate tax deduction for contributions to these accounts, all of the profits go to the investor. The government receives its share at the outset, then current account income and qualified distributions are never taxable. As a result, $1 million in a Roth account is worth significantly more than $1 million in a tax-deferred account, because the balance in a Roth account can be spent during retirement without having to pay any taxes. Another benefit of Roth IRAs in particular is that the IRS does not require distributions from them the way it does from traditional retirement accounts (though such distributions are required from Roth 401(k)s).

Of course, there are drawbacks to tax-free accounts, too. For one, funding a Roth account is more difficult. It takes $15,385 of pre-tax earnings to contribute $10,000 to a Roth account, assuming a 35 percent tax rate. In addition, there’s always the possibility that future legislation could decrease or eliminate the benefits of Roth accounts. If, for example, the federal government or individual states lowered tax rates or shifted to a consumption-based tax system, a Roth IRA would have been a poor choice compared with a traditional IRA, since there is no upfront tax benefit.

Choosing Which Account To Fund

Some rules of thumb can help you determine which types of retirement accounts to use. First, you should have sufficient safe, easily accessible assets in a taxable account as an emergency fund. Six months of living expenses is a good starting point, but the actual amount varies based on your expenses, the security of your current job and how quickly you could get a new job. Funds that you will need access to before retirement should also be kept in a taxable account.

Next, consider how much you can contribute to tax-advantaged accounts. The following chart provides the contribution limits for different types of retirement accounts for 2015.


Traditional and Roth IRAs
IRA Contribution Limit$5,500
IRA Catch-Up Contributions$1,000
401(k), 403(b), Profit-Sharing Plans, etc.
Elective Deferrals$18,000
Catch-up Contributions$6,000
Defined Contribution Limits$53,000
SEP Maximum Contribution$53,000
Defined Benefit Limits$210,000
457 Elective Deferrals$18,000
SIMPLE Maximum Contributions$12,500
Catch-up Contributions$3,000

Adapted from www.irs.gov

If an employer matches contributions to a retirement plan, you should, when possible, contribute enough to get the full match. Any employer match will automatically be allocated to a tax-deferred account, but you should determine whether the plan will provide a match even if you contribute to a Roth account.

The common wisdom says that you should contribute to a traditional IRA or 401(k), rather than a Roth IRA or 401(k), if your current tax bracket is higher than the tax bracket you expect to occupy in retirement. If the reverse is true, a Roth IRA is the default choice. Although these guidelines are good starting points, savers are generally best served by keeping some assets in each type of account — which is the idea of tax diversification.

People’s lives and future tax legislation are inherently uncertain. Even if you expect your federal tax bracket to remain the same in retirement, it might go up if tax rates go up overall or if you move to a higher-tax state. There is no way to know exactly what your situation will look like in any given year of your retirement. You should have some assets in each type of account, but the particulars of your circumstances will dictate their relative size. As with other sorts of diversification, there is not a one-size-fits-all plan.

Going Above And Beyond Retirement Savings Limits

Selecting the best retirement plans for your situation is beyond the scope of this article, but some planning can allow you to funnel much more money into tax-advantaged accounts than you might have otherwise expected.

Consider whether you are eligible for one of the higher-limit plans in the table above. Some employers offer defined contribution plans with higher limits than a 401(k), and it is very easy for self-employed individuals to set up SEP IRAs. For high-earning small-business owners, it may be worthwhile to set up a defined benefit (pension) plan, which can allow for much higher contributions. Certain employers also offer nonqualified savings accounts that allow you to defer income in excess of the limits for the qualified plans listed here, but they add different risks.

Besides employer-sponsored plans, annuities and life insurance can also offer tax advantages, but most savers should proceed cautiously. Annuities provide tax deferral, but lack the upfront tax benefit that makes other tax-deferred accounts so appealing. Also, distributions from annuities are taxed at ordinary income tax rates, so if your tax rate is expected to remain high through retirement, you effectively allow the government to take a higher share of your profits than would be the case in a taxable account. If your income tax rate is expected to drop substantially in retirement, certain annuities can be effective savings vehicles once you have exhausted your other options. In many cases, the higher costs of life insurance products outweigh their tax benefits.

If you want to funnel more money into a tax-free account, you might consider converting a portion of your tax-deferred retirement accounts to a Roth IRA. You will have to pay tax on the income at the time of the conversion, but if you expect your tax rate to remain the same or increase in the future, it may be profitable to shift some funds to a Roth. Finally, if you plan to use any of your savings to fund education expenses for a child or grandchild, you might consider funding a Section 529 college savings account. The investments in such accounts grow tax-deferred, and any distributions used for qualified education expenses are tax-free.

How To Spend Down Retirement Accounts

The order in which you withdraw assets during retirement is just as important as the choice of which accounts to fund. By mindfully selecting which account you withdraw from each year, you can lower what you pay in taxes.

The first assets you spend should typically come from your taxable accounts. However, in a low-income year, when your income tax rate may be lower, it may make sense to pull some funds from a tax-deferred account. In some cases, you can take taxable distributions without generating any tax liability at all. Spending from tax-deferred accounts may also make sense if your taxable accounts have highly appreciated securities that you plan to hold until death. Run tax projections each year to weigh the benefits of withdrawing from a taxable or a tax-deferred account.

Aim to keep assets in your Roth accounts for as long as you can, allowing the investments to continue to grow tax-free while you deplete other assets that generate tax liability.

For most retirees, no two years will look alike. More important, there is no way to know decades in advance what a given person’s tax situation will be throughout retirement. As with any long-term investment plan, it is essential to create a strategy that is flexible and can work even when circumstances change. By taking care to diversify the tax character of your accounts, you build in choices that will allow you to adapt to a variety of financial situations much more easily and, ultimately, to preserve more of your diligently saved retirement funds.

Senior Client Service Manager and Chief Investment Officer Benjamin C. Sullivan, who is based in our Austin, Texas office, contributed several chapters to our firm’s recently updated book, The High Achiever’s Guide To Wealth, including Chapter 5, “Investments: Fundamentals, Techniques And Psychology,” and Chapter 14, “Employment Contracts.” He was also among the authors of the firm’s book Looking Ahead: Life, Family, Wealth and Business After 55.
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