When planning for future finances it’s important to recognize that people are living longer. In fact, average life expectancy in the United States set a record of 78.8 years in 2012. While longevity may inspire people to think about more things they can do in retirement, it can also add to the challenge of creating a sustainable source of income.

Outliving savings is a concern for some investors. But longevity is not the only risk. Market risk, volatility, and inflation may erode savings. Relying on Social Security, given questions surrounding its long-term solvency, could also pose a problem.

Taxes are another risk. With federal marginal rates on certain income as high as 43.4%, and with additional income taxes in some states, many individuals may find more than half of their income is subject to taxation.

Using a tax-efficient retirement income strategy may help mitigate the impact of higher taxes. Here are several strategies for optimizing tax-efficiency in retirement.

Tax diversification
The tax status of assets in retirement and how funds are allocated among them is an important aspect of tax planning. Many retirees place a disproportionate percentage of their overall savings in tax-deferred retirement accounts. However, at withdrawal these assets could be taxed at a rate as high as 39.6%.

Investors can create tax diversification by allocating assets over time across taxable, tax-deferred, and tax-free sources. Retirees will have flexibility to draw income from different sources depending on their individual tax situation and changes in life circumstances.

Strategies to achieve tax diversification may include holding a larger percentage of taxable fixed-income assets in municipal bond funds. Investors may also consider funding a Roth 401(k) account, rolling over a retirement plan distribution to a Roth IRA, or converting a traditional IRA to a Roth. Roth distributions are not taxable if requirements are met.

A tax-efficient withdrawal strategy
When it comes time to withdraw funds for retirement income, the conventional wisdom is that retirees should take money from accounts in the following order: taxable, tax deferred, and then tax free. The goal is to preserve tax-deferred assets for as long as possible. But depending on an individual’s tax situation, the conventional wisdom may not be the best course of action.

A related strategy is for retirees to draw income from different tax sources as they gradually transition from lower to higher tax brackets, that is, draw enough income from tax-deferred sources such as traditional IRAs or 401(k)s to reach the limit of the lower income tax bracket. This approach maximizes the use of the lower tax bracket for ordinary income. As more income is needed, consider drawing from other sources to avoid increasing ordinary income.

Planning for sustainable income in retirement is challenging. But by using a combination of fundamental and advanced strategies, a financial advisor can help investors succeed. For more detail on these ideas and others, see “Developing a tax-smart retirement income strategy.”