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Best Tax Diversification Strategies for Retirement

February 19, 2024

Best Tax Diversification Strategies for Retirement


The famous saying "Don't put all your eggs in one basket" holds true not only for individual stocks but also for your retirement tax liability. This is especially important for high-income individuals like physicians. To ensure a secure future, it is crucial to adopt a tax diversification strategy.


Tax diversification involves building wealth in three different "buckets" that are subject to different tax rates upon distribution in retirement. By diversifying your assets across these buckets, you can maximize your options and minimize your tax burden.


The first bucket consists of assets like 401(k)s and IRAs, where contributions are made before taxes are withheld. During retirement, these assets are taxed as ordinary income. The second bucket includes brokerage accounts and trusts, where only the investment gains are subject to capital gains tax rates. Lastly, the third bucket comprises after-tax assets such as Roth IRAs or Roth 401(k)s. Contributions to these accounts are made after taxes are withheld, and future distributions are tax-free.


By spreading your wealth across these three tax buckets, you position yourself strongly for the long-term. This strategy allows you to adapt to changing tax rates and gives you flexibility in withdrawing income during retirement. Remember, a diversified tax portfolio is just as important as a diversified investment portfolio when it comes to securing your financial future.


Version 2: Diversifying your retirement savings across different tax buckets can provide significant advantages when it comes to managing taxes during your distribution years. While many physicians are drawn to the pre-tax bucket due to its immediate tax benefits, relying solely on this option may limit your flexibility in the future when you need to withdraw more than the annual required minimum distribution.


By strategically considering the maximum amount you can withdraw in a tax year before entering a higher tax bracket, you can have more control over your retirement plan withdrawals. This allows you to optimize your tax situation and potentially minimize the amount of taxes you owe.


On the other hand, if you wait until the required age for withdrawals, you have no control over the specific amount you need to withdraw. The IRS determines this amount based on their life expectancy tables. This lack of control can be problematic if you have unexpected expenses or if you want to withdraw a larger sum for a specific purpose, such as purchasing a second home or funding a child's education.

By diversifying your retirement savings across different tax buckets, such as Roth IRAs or taxable investment accounts, you can create a more flexible and tax-efficient retirement plan. Roth IRAs, for example, allow for tax-free withdrawals in retirement, as contributions are made with after-tax dollars. This can be advantageous if you anticipate being in a higher tax bracket during retirement or if you want to leave a tax-free inheritance to your beneficiaries.


Additionally, having funds in taxable investment accounts can provide even more flexibility. These accounts allow you to withdraw money at any time without penalties or restrictions. While you will owe taxes on any capital gains or dividends earned, having this option can be valuable if you need to access funds before reaching retirement age or if you want to supplement your retirement income with additional withdrawals.


In summary, diversifying your retirement savings across different tax buckets can provide you with more control and flexibility when it comes to managing taxes during your distribution years. By considering the maximum amount you can withdraw in a tax year and strategically utilizing different tax-advantaged accounts, you can optimize your retirement plan and potentially minimize your tax burden.

By evenly distributing taxable income throughout retirement, you have the potential to reduce taxes on Social Security benefits and Medicare premiums. To illustrate this concept, Fidelity conducted a comparison between the traditional approach and a proportional withdrawal strategy using a hypothetical example:


Meet Joe, a 62-year-old single individual. He has $200,000 in taxable accounts, $250,000 in traditional 401(k) accounts and IRAs, and $50,000 in a Roth IRA. Joe receives $25,000 per year in Social Security and requires a total after-tax income of $60,000 annually. This is assuming a 5% annual return.


If Joe follows the traditional approach, withdrawing from one account at a time (starting with taxable, then traditional, and finally Roth), his savings will last just over 22 years. Throughout his retirement, he will pay an estimated $66,000 in taxes. It's important to note that with this approach, Joe experiences a sudden "tax bump" in year 8, where he pays over $5,000 in taxes for 11 years, while paying nothing for the first 7 years and nothing when he starts withdrawing from his Roth account.


Now, let's consider the proportional approach. This strategy spreads out the tax impact, significantly reducing it. As a result, Joe's portfolio will last slightly over 23 years. Additionally, this strategy will cost Joe approximately $41,000 in taxes over his retirement and provide an extra year of retirement income.


When it comes to long-term planning, flexibility is crucial. Regardless of the tools or strategies used, a fundamental aspect of any retirement plan should be the ability to adapt to changes in tax rates, income needs, market performance, and personal health. Incorporating tax diversification and QRP withdrawal strategies is just one part of a comprehensive long-term plan.


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