If you\u2019re planning for retirement, you\u2019ve probably spent a lot of time focused on ways to save and invest money wisely. If you\u2019re a little more experienced than the average saver, you may also focus on portfolio diversification to minimize risk.<\/p>\n
But even sophisticated and experienced investors sometimes overlook \u201ctax diversification.\u201d<\/p>\n
The default assumption is that the 401(k) should be maxed out for maximum tax efficiency, but the reality is more nuanced. In practice, you may benefit from allocating your savings across a mix of traditional tax-advantaged and ordinary brokerage accounts to improve tax flexibility, according to U.S. Bank. (1)<\/p>\n
Here\u2019s why an appropriate mix of accounts can help you save money and preserve financial flexibility in retirement.<\/p>\n
The government offers tax incentives to encourage savings, but each account comes with different rules, limitations, and advantages.<\/p>\n
The first step for investors is to learn about the different retirement and investment accounts available and how they are structured.<\/p>\n
Traditional accounts like 401(k) plans and traditional IRAs offer an upfront tax deduction but create a tax liability when funds are withdrawn at retirement. Roth accounts work the opposite way: You pay taxes upfront before contributing and then enjoy tax-free withdrawals later if requirements are met.<\/p>\n
The Health Savings Account (HSA) is often described as having a \u201ctriple tax advantage\u201d:<\/p>\n
After age 65, withdrawals for non-medical expenses are taxed as ordinary income, similar to a traditional IRA, but without the early-withdrawal penalty.<\/p>\n
The final, and perhaps most overlooked, piece is the brokerage account. These accounts generally offer no special tax advantages for contributions, growth, or withdrawals. But in exchange for this lack of tax preference, they provide significant flexibility: no age limits, no penalties, and no required minimum distributions (RMDs).<\/p>\n
It\u2019s wise not to overemphasize any one of these tools. Too much money concentrated in your 401(k) may increase the likelihood of large RMDs in retirement. Too much in Roth accounts could mean paying more taxes upfront than necessary. Meanwhile, a large HSA balance could eventually be used for non-medical expenses that are taxed as ordinary income.<\/p>\n
Story Continues <\/p>\n
Read More: 5 essential money moves to make once you\u2019ve saved $50,000<\/a><\/p>\n The right mix for you depends on your financial goals and timeline, but also on your expected income and tax bracket over time.<\/p>\n Tax diversification often becomes more valuable as you accumulate capital. If you\u2019re a multimillionaire, for instance, there\u2019s a good chance you\u2019ve maxed out your tax-advantaged accounts and may face a higher future tax burden or large required withdrawals.<\/p>\n To optimize your strategy, Ameriprise Financial suggests starting early and implementing long-term plans while you\u2019re still actively building wealth. (2)<\/p>\n Divide your planning timeline into three categories: working years, pre-retirement, and retirement. During your working years, your focus should often be on tax-deferral through 401(k) and HSA accounts, but it can also be beneficial to contribute to Roth accounts when possible. Use Roth contributions as part of long-term tax planning during your working years.<\/p>\n In the years leading up to retirement, or pre-retirement, you may consider strategies like Roth conversions to minimize future RMDs later.<\/p>\n You could use net unrealized appreciation (NUA) rules to convert some employer stock assets in your 401(k) so a portion may be taxed at capital gains rates rather than ordinary income. But given the complexity of this strategy and the rules around it, you should speak with a financial advisor first. (3)<\/p>\n If you\u2019ve diversified your assets well, you have greater flexibility to control withdrawals from different accounts during retirement. This control can potentially reduce your overall tax burden.<\/p>\n Assume a retiree has $1.5 million and needs $40,000 per year from savings (on top of Social Security benefits).<\/p>\n Every dollar withdrawn is taxed as ordinary income. At an assumed 22% effective rate, that\u2019s about $8,800 in annual tax. Over 30 years, that\u2019s roughly $264,000 in taxes.<\/p>\n Add RMDs starting at age 73. Those forced withdrawals can push income higher, potentially trigger taxes on up to 85% of Social Security benefits, and raise Medicare Part B and Part D premiums through IRMAA surcharges. Depending on circumstances, that could add tens of thousands of dollars in additional taxes and costs over time.<\/p>\n Total long-term tax hit: potentially $300,000 or more depending on tax rates and withdrawals.<\/p>\n Now withdrawals are blended. Some are tax-free (Roth). Some may be taxed at long-term capital gains rates (taxable account). Only part is taxed as ordinary income.<\/p>\n Annual taxes could fall to about $6,800 under the same assumptions, because the effective tax rate would be lower. Over 30 years: roughly $204,000. That\u2019s a difference of around $100,000 \u2014 simply from having multiple tax buckets.<\/p>\n Beyond a certain level of wealth, tax diversification can become nearly as important as portfolio diversification.<\/p>\n The right mix of accounts and a thoughtful long-term withdrawal strategy may significantly reduce taxes and increase flexibility in retirement.<\/p>\n Join 250,000+ readers and get Moneywise\u2019s best stories and exclusive interviews first \u2014 clear insights curated and delivered weekly. Subscribe now.<\/a><\/p>\n We rely only on vetted sources and credible third-party reporting. For details, see our editorial ethics and guidelines<\/a>.<\/p>\n U.S. Bank (1<\/a>); Ameriprise (2<\/a>); Fidelity (3<\/a>)<\/p>\n This article provides information only and should not be construed as advice. It is provided without warranty of any kind.<\/p>\n","protected":false},"excerpt":{"rendered":"If you\u2019re planning for retirement, you\u2019ve probably spent a lot of time focused on ways to save and…\n","protected":false},"author":2,"featured_media":385936,"comment_status":"","ping_status":"","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[14],"tags":[51627,72,1890,176,61,60,27878,122789,174,175,122881,1615,171700,165768,171699,171698],"class_list":{"0":"post-385935","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-personal-finance","8":"tag-brokerage-accounts","9":"tag-business","10":"tag-dave-ramsey","11":"tag-finance","12":"tag-ie","13":"tag-ireland","14":"tag-medical-expenses","15":"tag-ordinary-income","16":"tag-personal-finance","17":"tag-personalfinance","18":"tag-portfolio-diversification","19":"tag-social-security","20":"tag-tax-efficiency","21":"tag-tax-advantaged","22":"tag-tax-free-withdrawals","23":"tag-traditional-accounts"},"_links":{"self":[{"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/posts\/385935","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/comments?post=385935"}],"version-history":[{"count":0,"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/posts\/385935\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/media\/385936"}],"wp:attachment":[{"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/media?parent=385935"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/categories?post=385935"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.newsbeep.com\/ie\/wp-json\/wp\/v2\/tags?post=385935"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}