Tax Diversification: Why It Is Important to Retirement Financial Planning

There are limits to what we can control. With investments we may not be able to control our returns but we can control our expenses including our tax liability. A well diversified multiple asset class portfolio will help control risk and volatility. Index funds can decrease investment expenses. Tax deferred investments (IRA's, 401k's, etc.) decrease our current income tax liability by pushing the tax bill off into the future when we hope we will be in a lower tax bracket.

With a fixed income in retirement, it becomes even more important to control the expenses that we can. Taxes could turn out to be a retiree's largest expenses. A financial plan now that offers options, tax diversification options, could decrease your income taxes in your golden years.

We assume that we will be in a lower tax bracket in retirement, but we can't be sure. We have no guarantees that tax laws won't change. What if our future tax bracket turns out to be the same or even higher than it currently is? What if our progressive income tax becomes even more progressive? We could owe more taxes in retirement than we are planning on.

Since it is difficult to predict the income tax rates in the future, choosing the right type of account to place retirement savings can be difficult. Not sure what tax bracket you'll be in 20 or 40 years from now, keep your options open. A tax diversified portfolio will allow a retiree some choice as to which accounts to withdraw funds from to minimize their tax liability.

To develop a tax diversified portfolio, you have to understand the IRS rules. For tax purposes, investments can be held in 3 general types of accounts: taxable, tax-deductible/tax-deferred, and tax-free.

• Taxable Accounts

Taxable accounts (savings accounts, CDs, mutual funds, brokerage accounts) hold after tax dollars. Growth such as interest, dividends, or capital gains are taxed the year in which you receive them. In general, withdrawals are not taxed (sale of an asset such as a mutual fund are an exception). While capital gains are taxed, capital losses can be used to reduce taxable income.

Another exception is municipal bonds. They are purchased with post-tax dollars but interest from these bonds is not taxable as income. But, sale of these bonds could result in a taxable capital gain or loss.

• Tax-deductible/Tax-deferred Accounts

Contributions to tax-deductible/tax-deferred accounts (traditional IRAs, 401(k)s, 403(b)s, SEP-IRAs, etc.) are in usually with pre-tax dollars (tax-deductible). Investments in these accounts grow tax-free and are not taxed until funds are withdrawn (tax-deferred). Pre-tax contributions as well as any investment growth is taxed as income when funds are withdrawn. After age 70 1/2, Required Minimum Distributions (RMD) mandate that a minimum amount be withdrawn from these accounts and subsequently be taxed as income in the year received. Non-deductable traditional IRA contributions and annuities grow tax deferred but only the growth of the investment and not the basis (post-tax dollar contributions) are taxed upon withdrawal.

• Tax-free Accounts

Tax-free accounts (Roth IRAs, Roth 401(k)s, cash value life insurance) with their post-tax contributions grow tax free and are not taxed when funds are withdrawn. With a few exceptions, these accounts usually have no Required Minimum Distribution (RMD).

Diversification of investments across these 3 types of accounts can be utilized to minimize income tax liability when funds are withdrawn in retirement. Above certain income thresholds, social security benefits will be taxable. The higher your taxable income is, the higher the marginal rate your social security benefit will be taxed at. In addition, medicare premiums will increase for certain very high income individuals.

If your only income in retirement is your social security benefit, you will not owe any federal income tax on this income. But, with a little interest income, a part-time job, a pension or IRA account and quickly up to 85% of your social security benefit becomes taxable. Now income tax can make a significant dent in your retirement cash flow.

Lets assume a retired couple in 2013 received about the average social security benefit ($22,950 combined). He has a company pension and she has a small IRA (total distribution $30,000). The have a total of $20,000 in taxable income from part-time employment and taxable interest. This income will be enough for the couple to reach the threshold that results in 85% of their social security benefit ($19,508) being included in their taxable income.

For this limited discussion, dividends and capital gains were purposely left out of this example because of the complexity of how they may be taxed and the fact that they are usually taxed at a lower rate than a tax payer's marginal tax rate. If this couple had capital gains and/or dividends, their total tax liability would have been lower in both cases presented here.

This couple's adjusted gross income (AGI) is $69,508 (total income is $72,950 including the untaxed portion of their social security benefit). After subtracting the couples standard deduction and two exemptions, the couple's taxable income is $47,108. Their federal income tax liability is $6,176 or 8.5% of their total cash flow for the year.

If half of this couple's pension and IRA income ($15,000) came from tax-free Roth accounts, their total income would have remained $72,950 but their AGI would have decreased to $43,104 (only $8,104 or 35% of their social security benefit would have been included in their taxable income). After subtracting their standard deduction and two exemptions, their federal income tax liability would be $2,216 or 3% of their total income, a savings of $3,960 (or $330 per month!). I don't think there is anybody that wouldn't like $330 more per month in after tax income.

By using a tax diversification portfolio and withdrawing part of their income from a tax-fee account, the couple decreased the taxable portion of their social security benefit and decreased their overall tax liability by more than 60%. If an emergency arose such as the need for a new roof or major car repair, any additional withdrawals from a savings account, the Roth accounts or cash value life insurance would have increased their total income without increasing their tax liability one penny.

In planning your tax diversification strategy remember that any interest received from municipal bonds is tax free, but the interest is included in the calculation of the portion of your social security benefit that is taxable. So for this couple, municipal bond interest could have increased their tax liability because it would have increased the amount of social security benefit that would have to be included in their taxable income.

If this couple had sufficient deductions to itemize, they could have lowered their taxable income and further reduced their tax liability.

What happens if you have a higher retirement income? The more retirement income that is tax free, the greater your tax savings.

Lets take the same couple as above and increase their taxable income and interest to $25,000. Their total social security benefit is increased to $47,400 (one spouse maximum benefit and the other spouse 1/2 of the maximum) and their IRA/pension distribution is $75,000. Their taxable social security benefit is $40,490 and their AGI is $140,290 (total income including untaxed social security benefit is $147,400). Their total federal tax liability is $21,330 or 14.5% of their total income. (Again no capital gains or dividends for the reasons noted above).

If half ($37,500) of their IRA/pension distribution came from a tax-free source, their AGI would decrease to $102,790 (their total income would still remain $147,400). With income from a tax-free source, the couple's federal tax liability would decrease to $11,951 (8.1% of their total income). This change in the source of income results in a savings of $9,379 or $782 dollars per month.

Unlike the example above, because this couple's total income is so high, decreasing the portion of their income from taxable sources does not decrease the taxable portion of their social security benefit. Because the maximum portion of their social security benefit (85%) is already taxed, additional tax-free income, such as from municipal bonds, would not increase this couples federal tax liability.

If this couple itemized their deductions, they could have further lowered their taxable income and total tax liability.

Circumstances can vary among individuals. Maybe you won't work in retirement, but you may have taxable income from rental property, higher taxable interest income or maybe some tax free interest income. Your social security benefit or a pension could be higher or lower. You could have dividend paying stocks or have sold some stock or mutual funds and realized a capital gain (or loss). While dividends and capital gains are taxable, they are taxed at a lower rate than your marginal income tax rate. Maybe you took money from a cash value life insurance policy (loan or withdrawal), which, in most cases, would not increase in your tax liability.

Basically, for joint filers, once you have about $20,000 or more in taxable income it is likely that some portion of your social security benefit will be taxed. The higher your taxable income the more of your social security benefit that is subject to income tax. Eventually, 85% of your benefit is taxable.

It is very unlikely that anyone's tax situation mirrors the examples above so don't get lost in the specifics. The point is, work with the examples and see where your situation is similar and where it is different. Identify possible changes in your investments that you could make now. You will get a rough idea of how tax diversification now could lower your income taxes in retirement. If making a change now can save several hundred dollars a month in retirement, the change could be worth it. A qualified financial adviser can help you develop a tax diversification strategy that is right for your portfolio.

• There is no guarantee that your income tax rate will be lower in retirement.
• Social security benefits (up to 85%) may be taxable.
• Income taxes can be one of a retiree's largest expenses.
• Developing a tax diversified retirement portfolio can decrease your future income tax liability.
• The account you withdraw funds from in retirement can significantly affect your federal income tax liability.
• Dividends and capital gains are taxed at a lower rate than your marginal income tax rate. Capital losses can be used to reduce capital gains or reduce taxable income (up to $3,000).
• Get started early. Save in tax-free accounts (Roth IRA, etc.) when your taxes are lower early in your career.
• In pre-retirement, when you may have cut back to part-time work, your marginal tax rate will likely be lower. Take this opportunity to finalize and adjust your tax diversification strategy with conversions, roll-overs, or contributions to tax-free Roth accounts.

Any federal tax or tax planning information provided above or linked to this article is not meant to be specific to any particular individual or situation. Anyone who wishes to apply this information should first discuss it with an accountant, financial adviser, or tax professional to determine its appropriateness or how it specifically applies to their unique situation.