All About Tax Diversification: How to Pay Less in Taxes in Retirement

The concept of tax diversification might not be the first topic that springs to mind when planning for retirement, but it can have a profound impact on your ability to live out your golden years as you want. While Uncle Sam will (almost) always get a portion of your hard-earned and wisely-invested money, understanding how and when different types of accounts are taxed can help you keep more money for yourself, whether that means going on more vacations, passing more on to the next generation, or opting for the Macallan 30 Year instead of the 18.

In this episode of Capital Conversations, CERTIFIED FINANCIAL PLANNER™ professional Colin Day and portfolio manager Ryan Potts discuss how to best optimize your tax diversification, why you need to do it, the "One Bad Year Rule," and the importance of maintaining flexibility in your retirement funds.

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Below is the transcript for our most recent podcast, "All About Tax Diversification: How to Pay Less Taxes in Retirement."

Colin Day: Hi, everyone. Welcome back to another Capital Conversation. My name is Colin Day. With me today, Ryan Potts. Mr. Potts, how are you today?

Ryan Potts: Always doing great. It's a pleasure to be back on again.

Colin Day: You know, it's interesting because every day that we do one of these, I look outside, and it's different kinds of weather, and it's the first thing that I always want to remark on. It's cold and dreary for a lovely April afternoon here in Clayton, Missouri.

We just came from Nashville, which was just cold and dreary – or at least I did. You were stuck here, hanging out in St. Louis. But when I look outside and I think of the kinds of things that could be more dreary than the weather outside, it's taxes.

Ryan Potts: Ah. That's it, right? That's the conversation?

Colin Day: No. No, no, no, that's exactly what we're doing. Didn't you read the memo?

Ryan Potts: I did.

Colin Day: Yeah. Today we are going to talk to you all about tax diversification and why it matters. This is tax season; as we are recording this we are just a week out from filing taxes. Ryan, I will ask the question. Did you file your taxes yet?

Ryan Potts: I did.

Colin Day: Good for you.

Ryan Potts: I was an early bird. February.

Colin Day: Some people say you should file early because they get worried about – from a security perspective – someone trying to file underneath your social security number or something like that. I, on the other hand, preach the opposite, which is I'm going to wait for the last minute, because – I mean, well, that's what I do.

But in any case, tax diversification is going to be the topic du jour today. I think a lot of people – because this is a sensitive time to talk about tax, it's important that we keep it in the conversation. And it really is an evergreen topic, because unfortunately, at least in my life, taxes have been something that have been relatively unavoidable.

I don't think you've avoided taxes either.

Ryan Potts: Not that I know of.

Colin Day: Yeah, legally speaking.

Ryan Potts: Legally, yes.

I think taxes is a really interesting conversation. Luckily for you and I, we're not CPAs, so we don't have to talk a ton about taxes.

Colin Day: That's true.

Ryan Potts: Today's conversation specifically is tax diversification. I guess my question I'll just kind of tee you off with is, what is tax diversification and what is it for clients? How is it part of a financial plan?

Colin Day: Tax planning is one of the major areas, or at least a component of areas, that financial advisors should be concentrating on for their clients. We go through the CERTIFIED FINANCIAL PLANNER™ program and learn about tax. You'll do a lot about tax. I thought tax was interesting enough that I continue to learn about tax, and that's how I got my enrolled agent designation.

Tax diversification from a client perspective is really the idea that – just like we preach diversification on the money that is in your account and how it's being invested – it's also, from a withdrawal perspective and contribution perspective, how those dollars might affect your taxes throughout the year.

For example, we can keep it as simple as saying: in your 401k plan at work, you might have a pre-tax deferral option or a Roth deferral option. So that pre tax deferral option as it's implied by the name, you're putting in money and you're not paying taxes on it yet. You're going to pay taxes on it eventually when you withdraw that money. And that's going to influence your current taxes because you're likely getting a tax deduction. I'm not including that money on my taxes now. I'm going to pay taxes on that later.

Whereas a Roth contribution, we're kind of doing the opposite, right? So we're paying those taxes now. And we're doing that with intention to pay that now so we don't have to pay the taxes later. So just like in this very simple example – which hopefully I haven’t lost people by verbally explaining this – the pre-tax contribution is a way of saying, “I think I'll pay less tax in the future, so I'm deferring my tax to a later date. Don't want to pay them now, it might be my highest earning years, I'll pay the taxes later when I withdraw the funds in retirement.” Whereas with Roth, you might be thinking, “I'm going to owe more in tax.” There is certainly a segment of the population in the United States that believes taxes are only going to go up.

And if that's the case, then you want to pay your taxes up front. That's where Roth is going to come into play. Pay the tax now, avoid paying the tax later.

So from a diversification standpoint, What we're doing here is we're just splitting up the different kinds of money that we'll have available to us to eventually do distribute to ourselves over time.

Does that make sense?

Ryan Potts: Yeah, absolutely. And obviously the third bucket is just normal taxable dollars, which would be the equivalent to a brokerage account. If you put money in, you hold it for more than 12 months, you sell it at a gain. That's a long term capital gain that doesn't apply to qualified dollars.

Colin Day: Right, exactly. Again, when we fast forward and we think about the implementation of this, everybody's gonna look a little bit different. But what we don't want is for someone to come to us in retirement and they only have one kind of money.

Ryan Potts: Right.

Colin Day: And for most folks in this scenario, this is gonna be pre-tax money because when they opened up their 401(k), maybe in the ‘80s or ‘90s when they first established it, they started to contribute. They got on a 30 to 40 year track of doing the same thing.

Now, when it comes to retirement, all their wealth is in their 401(k) in the pre-tax bucket and, well, shoot, what happens? Anything we take from that thing, we're going to add onto our income. You have one bad year, you're in a situation where it might not work out well for you. We're going to talk a bit more about the ramifications of tax diversification in a second.

So, Ryan, why don't you maybe coach us through a little bit about what that might look like from a portfolio perspective.

Ryan Potts: Yeah, absolutely. You alluded to it really well. With 401(k)s or IRAs, for the most part, we tend to see a lot of pre-tax dollars – tax deferred is another way to say it; however you want to say it, it's the same thing. But when someone leaves a job and retires, for the most part, they probably were making some kind of a tax deferred election. Those dollars are then rolled over to a qualified IRA. As we are withdrawing those funds, they're then taxed at ordinary income.

In a portfolio, it's important though – we talked about the bucket approach in our last conversation and how we have different strategies for different time horizons within the financial plan. For somebody in the accumulation phase, they may be adding extra money to an emergency savings account.

The big important thing from a portfolio standpoint when it comes to tax diversification is making sure that you're really taking advantage of the rules that the IRS has laid out for us within these different accounts.

A great, great example of this is again, that retiree who maybe has deferred dollars. They may also have made a Roth contribution to their 401(k). When they retire, they come to us and we talk about financial planning, retirement planning, the conversation around asset allocation and how is the portfolio going to be invested, we always take into consideration the fact that – if we allude back to that bucket conversation – that long term bucket of money is money that we plan on spending in 10, 15, 20 years. Maybe it's at the end of your retirement. Maybe it's money that doesn't get spent and it's going to get passed down to the next generation.

Based on those things, we want to say, “Well, which of the three buckets in terms of tax deferred, taxable, or tax free is going to make the most sense for us to be the most aggressive?” And in that scenario it would be the Roth account or a tax free account where we can take advantage of the fact that we know all the growth that we're going to accumulate. We can then pull out or gift tax free essentially. And I think that's really important because for someone who retires [pre-Required Minimum Distribution (often referred to as RMD)] we need to make sure that maybe their taxable dollars are a bit more conservative because those are the dollars they're going to spend first in retirement. Where the IRA might come in as that midterm bucket of money where it’s trying to earn a little bit more than inflation, but still a little bit more conservative than the Roth dollars or the dollars that we plan on spending at the end of retirement.

So from a portfolio perspective, the different tax buckets are also going to be invested differently.

Colin Day: Yeah. In terms of the kinds of securities that you might hold in different kinds of portfolios, that might matter, right? If you think about, “What are the tax implications not just now but in the future?”

So I think about holding on to a mutual fund in a taxable account. Well for some people that's not such a huge issue. But for some people it's a HUGE issue. I don't know if you have any examples that you want to give, but the one that I think of immediately is: If you've got more tax efficient vehicles in certain kinds of accounts, they make more sense. It's why a financial advisor doesn't recommend holding onto a municipal bond in your IRA.

Ryan Potts: Yeah, in a qualified account.

Colin Day: And for those, again, that are not familiar with municipal bonds, you might be spinning out interest, which is great for you. But the reason that people invest in them is because it might be tax free, right? But you put that in an IRA and unfortunately anything that grows in that thing is going to get included on your income. So that kind of security is not appropriate.

That's the kind of stuff that is a little bit more nuanced. As your advisors are building out your portfolio, I say obviously that I'm hoping that they're thinking of [that].

Ryan Potts: Yeah. I think mutual funds are just, in general, when we talk about tax efficiency, those mutual funds aren't that tax efficient. Especially active mutual funds that are constantly buying and selling individual securities at the end of every year. Those managers might kick off some kind of a capital gain.

If you hold that mutual fund in a brokerage account or a taxable account, well that's a tax bill that you're going to have to fork up that year. There's nothing you can do to circumnavigate it. If you have that mutual fund in a qualified account, i.e. an IRA or a Roth IRA, you don't owe anything on those capital gains within that account.

So, to your point, there [are] ways to be efficient and to optimize the tax diversification from a portfolio perspective as well.

Colin Day: Yeah. Going forward and thinking about the implementation of this and what it really means, it comes back to a lot of stuff that Ryan mentioned, and I'll just revisit something that I mentioned before.

The reason that we want to have intention with how we build out your portfolios from a tax diversification standpoint is, what I call the “One Bad Year Rule.” Which is: You might be retiring within the next couple of years. If you are in that bucket – which again happens, unfortunately, quite often – where all of your wealth is in your 401(k) and it's all on the pre-tax side. Well, if that's the case, when you say, “Colin, I need $3,000 a month to supplement my social security so I can live in retirement.” And I say, “That's wonderful. We can certainly set up that plan.” And we start to send out those payments of $3,000 a month. A year goes by and things seem to be going pretty well – until they're not.

You have the water heater that goes out. You have a major expense. Maybe your child is getting married and your 401(k) is all you’ve got to be able to afford the open bar, whatever package you're buying or whatever. You might be in a situation where you suddenly need a lot of money. Any money that we take from your 401(k) or your traditional IRA, those types of what we call qualified accounts, are going to get included at ordinary income tax brackets. The tax bracket system that we all enjoy in the United States says the more money that we make in a given year, the higher percentage that we have to pay to the federal government. It may also apply to your state, [depending] on where you're listening to this. But from the federal side, we have that one bad year where we were pretty consistent in terms of what we were withdrawing out of our accounts. We knew what our taxes were going to look like. And then you have a year where you need an extra $20,000, $30,000, $100,000, and now we're in a different bracket. We're paying a lot more tax than we anticipated. We might be breaking the plan a little bit of what we anticipated for you because we need additional expenses.

So again, one bad year is really why we preach diversification. Whereas if we had multiple different kinds of accounts, brokerage, Roth, different things to look at we'd have a lot more flexibility.

Ryan Potts: I think that last word that you just said, “flexibility,” is the most important part when it comes to the financial planning aspect, because like you said, you know, we can plan whatever we want. We don't have a crystal ball. We don't know what could potentially happen. We always talk about setting money aside in an emergency or a cash bucket. Taking advantage of the fact that you have some security. But not everybody has enough dollars in their savings account at the bank to cover an emergency. Then you get into pulling from the IRA or pulling from the 401(k).

I think the other interesting part too, is you're almost double dipping because now that you're pulling additional dollars from your IRA or 401(k), you need to come up with more money to pay the tax on the fact that you're withdrawing. So then it kind of becomes this. snowball effect of, “OK, we're withdrawing for one thing. Now we need to withdraw again just to pay the tax.” And it's like a double whammy. And it can really hurt our clients when they don't have the flexibility.

Colin Day: Absolutely. You just, you just prolong the problem to more years than what you anticipated once that tax bill comes due.

And I like that you said “crystal ball,” because the second thing that I like to remind people of is why we preach diversification is that we don't know what taxes are going to look like in the future. But I do know with pretty good confidence what they look like right now.

Ryan Potts: Yeah.

Colin Day: And what I do know is that the Tax Cuts and Jobs Act, which was passed at the end of 2017, basically reset the tax brackets from 2018 through the year 2025.

And so we are kind of in these artificially low tax brackets, which has incentivized more people to do more Roth related contributions. 401(k), IRA, wherever it might be, 403d, 457, to those types of accounts because we are incentivized temporarily to do so. And what I mean by that is that if we're paying less in tax, the burden of paying the taxes up front isn't as great.

Whereas if we fast forward to 2026, when the tax cuts and jobs act is going to sunset, now we're at a situation where now we do have to pay a little bit more. But if I've already prepaid my taxes at a lower rate, it'll work out better for me. What we don't know, because again, we don't have that crystal ball, is that this is an election year, and there's already fodder for whether or not that's going to be continued. And so maybe we're going to be in a situation where we'll enjoy these tax brackets longer, but because I can't say that for certain, and all I know is what's in front of me, I'm going to use that as an option.

The third thing that I'll just mention very briefly, is next gen planning. You touched on that a little bit thinking about, “Well, I'm putting my oxygen mask on first. I have the wealth that I'm going to be doing well with, me and my spouse [are going] to survive retirement for 30 plus years. If there is a situation, however, where you feel like you have saved too much – which is super rare. No one's ever told me “Colin, I'm so mad. I saved too much for retirement.” But in the case where you might be in a situation where you've done well, you've invested well, and you have wealth, to be able to facilitate the next generation besides just doing basic things like gifting – which is a completely different conversation – we might be thinking about the kinds of securities that we're going to hand off to somebody and what we're spending. For example, do we want to really spend our Roth dollars now or do we want to – quote unquote – “gift” it to our loved ones? Because if i've already prepaid the taxes and they inherit it once I pass, well, they don't have to pay the taxes. Or do I want to spend money in my taxable account? Because I know that they might get a step up in basis – again, technical terms, we could talk about it later – but it might benefit them so they don't have to pay as much on the gains.

Ryan Potts: Let me ask you from a listener's perspective, if I'm coming in and I want to work with Correct Capital or with Colin Day, and I am that person that put all my money in a 401(k) and I put it all in tax deferred. Let's say I am retiring before my RMD age. So let's call my retirement age 65.

What do I do as a listener to maybe try to implement tax diversification? Because I know right now I'm super concentrated in the tax deferred bucket, and I need to get some money in the Roth or in the taxable accounts. What are some strategies that you can implement?

Colin Day: The first one of course, is that we can convert. We can convert pre-tax dollars into Roth.

What that looks like is we are literally, probably in the case of a traditional IRA, taking that qualified money and we're moving over portions, not the whole thing. Portions in time. And the reason we do this in portions is because whatever we move over from pre-tax into Roth gets included in our income.

So we want to be hypersensitive to this because again, we enjoy a graduated tax system. It's progressive. So the more money we make the higher the percentage we pay to the federal government. So we want to do that within reason. Now if you're one that's retired and you're sitting on a hill of cash, that you are in the best situation possible because if you're living on the cash, and you're not earning anything, you might not be paying any taxes, as long as you haven’t elected for social security yet.

That's the Goldilocks zone that I talk about a lot with our clients, to say, “This is the window of opportunity to do our Roth conversions.” You might also say, “Hey Colin, I'm going to do the Roth conversions, or maybe I'm going to move money into my bank account, so I feel comfortable with this. But maybe I don't need this money for the next 3 to 5 years.” Well, that could be a taxable account situation, right? We have to pay the taxes on what we took out of the IRA. Now in the future I might be paying 0% long-term capital gains, 15% at worst. And that might still be lower than your current tax bracket.

So those would be some of the things that we would spitball and then determine, okay, what is the dollar amount? And then we work with your CPA – because we're not CPAs – to then determine, “Hey, how much do we think we can convert? How much money do we think we can move over so that we stay within a current tax bracket?”

Ryan Potts: Like you said, hypersensitive, there are tons of variables when it comes to a Roth conversion strategy or even a distribution strategy.

Again, I think the moral of this conversation is: Having diversification gives you the flexibility to kind of pull different levers to put yourself in a better situation. And there's not really more to it than that other than: Try to build the diversification before you retire, but understand that if it's not there upon retirement there are ways to get there.

Colin Day: Absolutely. You are not lost. You are not, you’re not stuck in whatever you think you are. You're not mired in qualified-hell, or whatever you want to call it. But there are ways that you can work with us as financial advisors or with your CPA to then determine what the next route is. Honestly, I could wax poetic about tax diversification all day, but we should probably call it there. I don't want our listeners or our viewers to have their eyes or ears bleed.

So we will leave it there for right now. Thank you so much for joining us on another Capital Conversation. Let us know if we can help you. Please like and subscribe and share and we'll talk to you in the next one.

The opinions expressed in this program are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.

As always, please remember investing involves risk and possible loss of principal capital. Please seek advice from a licensed professional. Correct Capital Wealth Management is a registered investment advisor. Advisory services are only offered.

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Tax diversification is an essential part of making sure you can stay financially healthy throughout retirement. As financial advisors, our goals at Correct Capital Wealth Management isn't just to help people retire, but to help them thrive in retirement. Whether you're years away from retirement or right at its doorstep, it's never a bad idea to evaluate, reassess, and adjust your financial plan and portfolio. If you're interested in Correct Capital's retirement planning services, give us a call at 877-930-4015, contact us online, or schedule an appointment with a member of our advisor team. It only takes 15 minutes to find out if we’re a good fit.