A tax diversification strategy may help investors cover their bases

A tax diversification strategy may help investors cover their bases

Planning for future taxes is difficult. Even with the expectation that tax reform is moving to the top of the congressional agenda this year, it is impossible to predict the outcome or what lawmakers will do in the future.

Diversification is generally viewed as a way to mitigate risk in investments. In an uncertain policy environment, it may make sense for investors to also consider tax diversification when planning for retirement income.

Many investors assume their tax rate will be lower in retirement. But some retirees could face higher tax rates. Factors that could move individuals into higher tax brackets include: drawing income from tax-deferred retirement accounts, realizing capital gains, losing deductions such as mortgage interest after a house is paid off, and earning income from working in retirement.

A tax diversification plan allows investors to draw income from different sources, and may help savings last longer.

The first step toward tax diversification is assessing the tax status of current investments. This worksheet can help investors identify the portions of their assets that are taxable, tax deferred, or tax free.

Understanding the tax status of assets can help determine potential tax exposure in the future. One challenge most retirees face is that a disproportionate amount of savings is held in tax-deferred retirement accounts, which is taxed as income when withdrawn.

Creating tax diversification means allocating assets over time across taxable, tax-deferred, and tax-free sources.

When planning, consider the advantages of the different account types:

Taxable: Allocating some assets, such as dividend-paying investments, to taxable accounts allows investors to take advantage of lower capital gains and dividend rates.

Tax deferred: These accounts can be important for the many investors who are likely be in a lower tax bracket in retirement.

Roth IRA: With its tax-free distributions, a Roth IRA account can be used as a hedge against higher taxes in retirement.

Once in retirement, investors can set up a withdrawal plan to help make savings last longer. A common strategy is to withdraw funds from taxable accounts first, followed by tax-deferred accounts, and then from tax-free accounts. This sequence may not be ideal for all investors, and guidance from a tax professional is recommended.

It may be appropriate to withdraw from tax-deferred accounts at a time when the marginal tax bracket is lower. This could occur early in retirement, before required minimum distributions begin at age 70½. Or the timing could be later in retirement, when medical expenses may be higher.

Strategically withdrawing funds from different accounts can also help investors maximize the use of tax brackets. For more details on tax diversification, read Putnam’s investor education piece, “Developing a tax-smart retirement income strategy.”

As with any retirement income plan, it is important to seek professional advice to help craft a saving and withdrawal strategy that fits an individual financial situation.

Diversification does not guarantee a profit or ensure against loss. It is possible to lose money in a diversified portfolio.


More in: Taxes