We are all familiar with some of the more common threats to our retirement savings. Inflation is a significant threat because it can make today’s dollar worth less in the future. An illness or injury that forces one to spend a large percentage of retirement savings on health care is another. Bad investment decisions and periods of sustained underperformance in the investment markets can also erode retirement savings. However, fewer people are familiar with an important but often overlooked threat to retirement savings — taxes.
Having to pay taxes can reduce the size of your retirement nest egg over time. However, there are strategies that can help minimize the impact of taxes on retirement savings. One of the most effective is tax diversification. It essentially involves spreading your retirement assets among accounts that are treated differently for tax purposes to achieve greater control over your taxes.
Taxable Accounts
When you invest in mutual funds,* stocks, bonds, and money market securities in a taxable account, any net realized capital gains, interest earnings, and dividends are taxable each year. The advantage of a taxable account, however, is that you don’t have to take annual required minimum distributions (RMDs) upon reaching age 73 (or other RMD age), so you can choose to withdraw your money when it suits your needs.
Roth Accounts
When you invest using after-tax dollars in a Roth IRA or a Roth 401(k) plan, investment earnings accumulate tax deferred, and withdrawals from the account will be tax free after you’ve had the account for at least five tax years and have reached age 59½. Investing in a Roth account could give you access to your retirement savings without the potential for being shifted into a higher tax bracket. And if you don’t need to withdraw money, you can simply leave it invested in your account — the RMD rules don’t apply to a Roth IRA or, starting in 2024, to a Roth 401(k) account during the owner’s lifetime.
Traditional Retirement Accounts
You won’t owe any taxes on the money you contribute to a traditional 401(k) or similar workplace retirement savings plan — or on tax-deductible contributions to a traditional IRA — until you make withdrawals. Investment earnings in these accounts are also tax deferred until withdrawal. Tax deferral lets your account grow faster than it would if taxes were paid on the income as it was earned. When you are retired and start taking withdrawals from your account, you may be in a lower tax bracket.
The Benefits of Tax Diversification
Diversifying across different types of accounts can give you greater control over when and how much you take from your retirement accounts. By spreading taxable distributions over a longer period, you may end up paying less tax and retain more of your savings.
The challenge is to determine the most strategic way to allocate your retirement assets among the different accounts. A tax professional can provide more insights on how tax diversification may work for you.
*You should consider the fund’s investment objectives, charges, expenses, and risks carefully before you invest. The fund’s prospectus, which can be obtained from your financial representative, contains this and other information about the fund. Read the prospectus carefully before you invest or send money. Shares, when redeemed, may be worth more or less than their original cost.
