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When building a retirement plan, investors have traditionally prioritized asset allocation, parking a sizable portion of their wealth in assets like equities, fixed income and bonds so it will grow before they retire. While this is a tried and true strategy, it only accounts for part of the equation. A portfolio’s gross return doesn’t reflect the full yield to the investor, as the IRS withholds a percentage.
To maximize returns and long-term wealth, it is highly advisable that investors also master tax diversification. Spreading retirement-related investments across accounts with different tax treatments provides flexibility and greater control over future tax rates. Think of this approach as an insurance policy against future tax hikes. If tax rates go up, holding capital in accounts that the government can’t touch will be a great defensive strategy.
1. Using the Three “Baskets” of Retirement Savings
To promote flexibility, consider categorizing your capital’s allocation into three distinct “baskets,” each with its own tax treatment. Taxes are known to be stressful, so being able to compartmentalize key concepts is highly important. The three categories include:
- The tax-deferred basket: This accounts for your typical 401(k) and IRA contributions. While you get a tax break now, you’ll eventually owe the ordinary income tax on every dollar you take out later.
- The tax-free basket: This is a collection of funds that comprises Roth IRAs and Roth 401(k)s. Growth and withdrawal are entirely exempt from federal taxes.
- The taxable buckets: This represents typical brokerage accounts. While they lack up-front tax breaks, they offer solid liquidity and are subject to good long-term gains.
2. Balancing Traditional and Roth Allocations
When deciding where to invest your next dollar for your retirement fund, it’s important to consider the long-term tax implications of a traditional retirement account. A traditional IRA allows personal retirement savings while offering the potential for immediate tax relief through deductible contributions.
While placing your capital in these accounts right now might feel like the smart choice as it lowers your tax bill, you are effectively taking a “loan” from the IRS, which will eventually have to be repaid.
When you put all your financial “eggs” in one traditional “basket,” you are likely to end up in a high tax bracket later in life when you eventually decide to withdraw your money. That’s why many investors compare a traditional IRA to a Roth IRA to achieve a sense of balance.
The traditional IRA is a solid choice if you’re expecting to be in a similar or lower tax bracket when it’s time to withdraw. Alternatively, the Roth IRA helps your capital grow effectively in the long term, thanks to compound interest.
3. Using Roth Conversion
If you have decided to put a majority of your savings in a traditional tax-deferred account, it doesn’t have to stay stuck there. A Roth conversion is a powerful tool to shift the tax burden. This process involves moving money from a traditional IRA to a Roth IRA so that you pay income tax on the converted amount in the present, while allowing your money to grow tax-free over time.
This strategy is less effective during lower-income years. For example, if you retire at 62 but don’t start taking Social Security until 57, your income will be lower during those five years. You can convert chunks of your traditional savings into your Roth account during that window. By doing this, you prepay the taxes at a lower rate now, so you don’t have to pay a higher one later.
4. Making a Health Savings Account a Secret Retirement Fund
Many see a health savings account (HSA) as a way to pay for medical services, but it can be an effective tax-diversification strategy when approached thoughtfully. While this method might seem unorthodox to some, there are three key reasons why it works:
- The money you put in lowers your taxes today.
- The money grows without being taxed.
- The money comes out tax-free if you use it for medical expenses.
The best-case scenario is using the funds for qualified medical expenses, as these withdrawals are completely tax-free. However, after age 65, the account essentially converts into a traditional retirement fund. You can withdraw money for any reason, and it will simply be taxed as regular income, just like a Traditional IRA. This flexibility is what makes the HSA a powerful retirement tool.
5. Identifying the Right Withdrawal Sequence When You Retire
The final step is determining the ideal withdrawal sequence for when you actually retire. A common mistake that investors make is withdrawing all the money from one account, potentially pushing them into a higher tax bracket.
A more sensible approach is to carefully manage your bracket, pulling just enough from your taxable or tax-deferred accounts to stay in a lower tax bracket. If you end up needing more money for that year, pull the rest from your tax-free Roth account. This keeps your overall tax rate as low as possible while ensuring you have a lifestyle you’re comfortable with.
The Importance of Finding a Personal Strategy
At the end of the day, the world of finance and investment is constantly evolving. What was right for your parents might not be right for you. The best retirement portfolio strategies are established by using your risk appetite and priorities to guide your retirement portfolio rather than following a formula that might not align with your values.
When it comes to developing a personalized investment strategy, having an experienced professional in your corner is invaluable. By consulting with a qualified financial advisor, you can ensure that your retirement is defined by your strategic vision rather than your taxes.
