• Monday, 8 April 2024

Tax Diversification as Retirement Approaches

Retirement planning requires thoughtful consideration of various factors, including investment and tax strategies. While stock diversification and portfolio balancing are frequently discussed, tax diversification is an equally critical but often overlooked aspect of retirement planning. Tax diversification can significantly impact your financial flexibility and income during retirement.

Let's break down tax diversification into three key areas or "buckets":

  1. Taxable Accounts: The first bucket consists of taxable accounts, such as checking and savings accounts, CDs, and retail investment accounts. These assets are taxed annually on interest or gains earned.
  2. Tax-Deferred Accounts: The second bucket includes tax-deferred accounts like Traditional IRAs, Traditional 401(k)s, pension plans, and deferred compensation accounts. Unless your income is below $44,000 for a married couple filing jointly in retirement, Social Security benefits may also be subject to taxation. These accounts are often popular for retirement savings due to their tax advantages during the accumulation phase.
  3. Tax-Free Accounts: The third bucket contains accounts that offer tax-free withdrawals, such as Roth 401(k)s, individual Roth IRAs, cash value life insurance, and municipal bonds. Keep in mind that municipal bonds can affect Social Security taxation through modified adjusted gross income (MAGI).

It is common for Middle America to have a checking, saving, Rollover IRA, and a Traditional 401K: two taxable and two tax-deferred accounts. This greatly reduces withdrawal options in retirement and increases risk as tax law changes are becoming more common and increasingly less advantageous as time goes on. An example would be needing a lump sum to pay a deductible for a new roof. Pulling extra from a Traditional IRA can have negative effects on social security taxation and increase that person’s tax bracket. Having the option to withdraw from a ROTH, retail investment account, or life insurance can help avoid that problem.

We have used many tools in the past, but the one we have found most useful is LEAP. This tool puts the individual or couple on a model with 27 financial drawers, allowing an advisor and client to see a snapshot of all their assets in one place. They can easily determine not only asset diversification but tax diversification. Using a financial model allows a person to test and verify various approaches to distributing assets in retirement It can help answer questions such as, “Which assets are most efficient to use first?  What if you only have one or two “buckets” vs. all three?  What strategy produces the largest net, after-tax income?”

By working with an advisor who understands tax diversification as well as the other kinds of diversification, one’s net after-tax income could be improved, the risk of tax law changes could be minimized, and the number of various incomes streams a person could access in retirement could be increased. Ultimately, a person could end up with more liquidity, use, and control over their wealth, which would lead to greater certainty of outcome.

By Aaron Peck, Managing Principal, 1847Financial – Dallas/Fort Worth and John Norman, CLU®, ChFC®, Financial Advisor



LEAP®️, Leap-The Model for Financial Success, The Leap Model, Macro Manager, Personal Macro Economics Process, Wealth In Motion®️, Protection, Savings, and Growth (PS&G) Model®️, and Lifetime Economic Acceleration Process are trademarks and service marks of Leap Systems, LLC which is an independent affiliate of Penn Mutual Life Insurance Company (PML). HTK is a wholly owned subsidiary of PML. Trademarks belong to their respective owners.

The LEAP process is for educational purposes only and should not be construed as investment advice. It is important to note that the implementation of any strategies provided as a part of LEAP are designed to aid one in reaching their financial objectives, but no assurance can be made that these objectives will in fact be reached. Individual results may vary.  LEAP is independent of HTK.  The views expressed are those of the presenting party and do not necessarily reflect the views of HTK or its affiliates.



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