Tax diversification is a strategy that can help investors achieve higher returns and avoid surprise taxes during retirement planning. Here’s what investors need to know about how to spread out investments to enjoy tax benefits upon retirement.
In this article:
- What Is Tax Diversification?
- Different Fund Types and Their Effect on Taxes
- Why There’s a Difference in Tax Structure for IRAs
- 401(k)s and Retirement Savings Options for the Self-Employed
Tax Diversification Retirement | Increase Retirement Planning Success with Tax Diversification
What Is Tax Diversification?
Regardless of age, anyone who’s part of the workforce has probably heard of or thought about retirement planning. An essential part of this is tax diversification, which is the strategy of placing funds into several types of accounts in an effort to minimize taxes upon retirement.
It can be difficult to predict one’s future income as well as how tax laws might change. Thus, spreading one’s retirement contributions out across several different types of accounts is a wise strategy.
Different Fund Types and Their Effect on Taxes
Different fund types have different tax schemes, and it’s essential for any investor to understand how each investment vehicle handles taxes to create a tax diversification strategy that works for them. Here’s what you need to know about taxation schemes for some popular investment vehicles, including the Traditional IRA, Roth IRA, and 401(k).
A popular option for investing during retirement is a Traditional IRA. In terms of tax structure, here are the things investors have to consider with this type of IRA:
- Traditional IRA and Tax Deferral — One thing people have to consider in terms of how taxes are handled in this type of IRA is that investors aren’t avoiding paying taxes — they’re merely delaying the inevitable.
- Minimum Deductions — Another thing to consider with the Traditional IRA is that you must begin taking minimum deductions by age 70 1/2. Regardless of the size of the IRA withdrawal you make, the IRS considers it 100% taxable income.
Unfortunately, the IRA distribution tax is sometimes much larger than people expect, hurting retirement planning.
How do taxes work in a Roth IRA? Here’s what investors need to consider for this investment vehicle:
- Any deduction an investor makes after 59 1/2 is tax-free.
- These deductions include income and contribution portions, as well as withdrawals and movement of funds between accounts.
- Typically, withdrawals made from Roth IRA accounts that are less than five years old will be subject to penalties and/or tax. The key to avoiding taxes when making Roth IRA withdrawals is to wait until the account reaches its five-year mark.
Opening a Roth IRA early in one’s working years and making maximum contributions can benefit an investor in a way they might not have considered.
The money they pay on taxes today could have a much higher tax rate decades from now upon withdrawal, which is a downside of delaying tax payments. If the investor went with a tax-deferred account, such as a Traditional IRA or 401(k), it’s highly probable they’ll have a higher tax burden when the time comes for IRA distribution.
Why There’s a Difference in Tax Structure for IRAs
Perhaps you wonder at this point why the difference in tax structure exists for an IRA withdrawal.
Traditional IRA Tax Structure
Traditional IRA lowers your taxable income the year you make contributions, which the IRS refers to as “pre-tax dollars.”
- An over-50 investor is single and earns an annual salary of $100,000.
- The investor decides to contribute $7,000 toward a Traditional IRA.
- A person’s taxable income would drop to $93,000 before you factor in other eligible deductions. Taxes will be deferred now but the investor pays them when they take the IRA distribution.
Roth IRA Tax Structure
The Roth IRA works in reverse since they don’t receive an immediate tax deferral. Instead, the IRS taxes the $7,000 the investor contributed toward the Roth IRA as a regular part of your income. Because of this, the investor doesn’t owe IRA taxes once they start making withdrawals from their account after they reach the age of 59 1/2.
This is because the initial contributions were made with after-tax dollars. The IRS can’t tax the investor again since they already paid taxes on the income even though it occurred decades ago.
401(k)s and Retirement Savings Options for the Self-Employed
Most larger employers today offer some type of retirement savings benefit to their employees, like the 401(k).
In this fund, the employee contributes their own pre-tax dollars. The employer may also provide employees with unearned income by matching contributions up to a certain percentage.
Most agree that leaving 401(k) funds untouched for as long as possible provides great tax benefits.
For example, if an investor already has a Roth IRA, withdrawing from it first before their 401(k) allows one to delay paying taxes because they’ve already paid them at the time of contribution.
For Self-Employed Individuals
Opening a Traditional IRA is a good option for those who are self-employed or otherwise have variable income. It allows them to contribute tax-free dollars on a flexible schedule that they can determine.
Other retirement savings options for the self-employed include Solo 401(k) or the simplified employee pension (SEP) IRA.
Every type of retirement savings account has advantages and disadvantages. Making diversification a priority in retirement planning allows an investor to tilt the benefits in their favor while minimizing any drawbacks.
Navigating the different tax structures and rules can be complex and tricky. Thus, it’s ideal to speak with a tax advisor to ensure one achieves the greatest diversification possible with their current retirement assets, while also establishing a strategy for avoiding taxes on IRA withdrawals after retirement.
What are your retirement planning strategies to reduce tax? Share your pointers in the comments section below.