Implementing a Tax Diversification Strategy

As you may have heard from your financial advisor, it’s not always how much you make but what you keep. Being tax aware — whether you’re in the accumulation, preservation or distribution phase of your financial life — can save a lot of money in the long term. It’s wise to invest tax smart, and decisions you make now can lessen your tax exposure, especially when you retire. So plan ahead and give yourself the opportunity to control your taxes in your 60s, 70s and beyond.

Many investors overweight accounts such as a 401(k), which can result in higher taxes in retirement. A tax diversification strategy allows you to accumulate money in three types of accounts. These are taxable accounts, tax-deferred accounts and tax-exempt accounts. When coordinated based on your current financial position, these three types of accounts can help maximize your retirement savings while minimizing current and future taxes.

1. Taxable accounts

For taxable accounts, taxes are due once realized in the current year at your regular tax rate on the money you earn. However, income from capital gains and qualifying dividends is taxed at either a long-term or short-term capital gains rate, which can be lower than normal income tax rates. An advantage of taxable accounts is that there are no required withdrawals or tax penalties if you take income out of these accounts before you turn 59½. As a result, you have great flexibility as to when you tap this income and which accounts you want to preserve for later in retirement.

Some retirees use the capital losses on their investments to help offset capital gains on others. Also, qualifying investments (e.g., real estate, stocks, bonds, mutual funds, etc.) within taxable accounts can receive a step-up in cost basis for your beneficiaries. Your financial advisor and tax specialist can help you make sense of what’s available in your specific situation and how to minimize your taxes in the long run. 

2. Tax-deferred accounts

With these accounts, your tax is deferred until you withdraw the money. Then the assets are taxed at 100% of your ordinary income tax rate. Typically, these are your 401(k), traditional IRA accounts, pension plans and annuities, and are a good way to grow your money on a tax-deferred basis. However, they can have drawbacks such as a lack of flexibility when you withdraw (e.g., taxes and penalties if withdrawn too soon). 

Lean on your financial advisor to help you choose how much to fund a tax-deferred account based on your financial needs today and your anticipated tax bracket during retirement. 

3. Tax-exempt accounts

The third bucket in a tax diversification strategy is money that accumulates and is tax-free upon withdrawal. A Roth IRA, the cash value of a life insurance policy[1], health savings accounts[2] and municipal bonds[3] can all be good examples of this type of account or investments. Because the money is invested on an after-tax basis (except for HSAs), withdrawals are tax-free. Plus, withdrawing money from a tax-free account won’t bump you up into a higher tax bracket. Be sure to check with your financial advisor or CPA on the impact to your provisional income if you are collecting Social Security. ^{1, 2, 3}

It’s best to take a coordinated approach to these types of accounts to accumulate assets efficiently — both from a growth and tax liability perspective. The goal of this strategy is that you can pull from each bucket as needed, keep your income below a certain threshold, and stay within a lower tax bracket. In doing so, you will have greater control over your finances now, and when you retire, which may help your assets last longer and may allow you to enjoy greater flexibility as to how you access your income during retirement.  

A tax diversification strategy is a smart approach for any investor but is especially important for high-net-worth individuals. It even helps avoid the income-related monthly adjustment amount (IRMAA) surcharge that can be added to monthly Medicare premiums. The surcharge is based on your annual income and can cost hundreds every month.

A trusted financial advisor can help you think through the ideal mix of taxable, tax-deferred and tax-exempt accounts so that you accumulate, preserve and distribute assets with a focus on maximum tax control 

Take a comprehensive approach to planning

The investment and financial planning strategy you put in place should be comprehensive. It needs to address your:

• Current and expected cash flow and debt management
• Investments
• Tax planning
• Risk management
• Retirement planning
• Estate planning

Through financial planning and by sticking to your plan, the probability of loss generally lessens as the time horizon lengthens. Historically, time in the market is more important than trying to time the market. Also, the tax rate on capital gains can be very different based on how long you hold an asset and what your annual income is. There’s even a difference if you sell an asset before the one-year mark. Your financial advisor can help you construct a plan that takes into account the assets you own and your required income during retirement. 

A tax-smart investment strategy should take state tax laws into consideration. For instance, some states tax all long-term capital gains less than ordinary income. Tax laws can be extremely complicated though and they change frequently. Make certain the financial advisor and CPA you work with are well versed in your state’s regulations. 

Is a gifting strategy right for you? If you have considerable wealth you want to transfer to someone, a tax-efficient gifting strategy may be a good option. Common gifting strategies include: 

• Donor-advised funds
• Charitable remainder trusts
• Qualified charitable distributions
• Family limited partnerships
• Grantor retained annuity trusts (GRATs)  

By using a qualified charitable distribution and taking it out of an IRA, you can help reduce your tax exposure.

As your income potential and tax laws change, your tax diversification strategy must change with them. Yellow Cardinal can help. As a large, trusted financial institution with a long history, you know our team will be here when you need us. Whether that’s today or years in the future when you retire, we can help with tax projections and adjust your strategy along the way so that you stay tax smart.