Investor Column | Be mindful of your tax diversification in retirement

A growing trend I have seen is people retiring with higher percentages of money held in traditional IRA accounts. As fewer companies offer pensions, it makes plenty of sense that the majority of savings these days are in 401K’s and other profit-sharing plans. According to the Employee Benefit Research Institute – as of 2016 there was $30.4 trillion in US retirement accounts. IRA’s represented 27% of those assets of which the Roth IRA represented 29% of those assets. I couldn’t get a figure, but my experience would guess that the percentage of Roth assets by age are skewed towards younger people. The Roth wasn’t created until The Taxpayer Relief Act of 1997.

IRA’s, 401k’s and other qualified plans have many benefits to the saver as they often get a deduction for their contribution and their earnings grow tax deferred. The downside is that once you are in the retirement / distribution phase the assets withdrawn are generally taxed at ordinary tax rates. At a younger age, the benefits of tax deferral are very compelling. The basic question will be, do I pay the tax and save in a Roth or do I take a tax deduction and save in a traditional IRA / qualified plan? There are several rules of thumb floating out there that try to simplify and address this question. The primary issue with these rules is that they assume retirement will follow the same precedents as when you move into retirement.

Retirement taxes are not quite the same as taxes while working. Retirees have taxable Social Security, Medicare income related monthly adjusted amount (IRMAA), Required Minimum Distributions and other tax traps that change the nature of their income. Additionally, now with the passing of the Secure Act, IRA assets are no longer available to be stretched for non-spouse beneficiaries who don’t meet certain standards. Having an overweight to traditional IRA assets can hamstring your ability to create a tax efficient withdrawal strategy for both the owner and their beneficiaries.

The over-arching theme here is that a well-diversified portfolio should not only have a good mix of stocks, bonds and cash but also a good mix of taxable, tax-deferred and tax-free accounts. Your ability to pull assets from different accounts to maintain proper flexibility can be of great benefit as you hit your 70’s and 80’s and are forced to take larger required minimum distributions from your traditional IRA accounts. By planning ahead today for future taxes years ahead you can potentially give yourself a good boost to your annual retirement income.

For those who find themselves over-weighted in IRA balances, consider using mini Roth conversions during low income years to back fill a particular tax bracket. There will be years in which you can adjust your tax rate by bunching deductions such as due to large medical expenses or making a large charitable contribution. Have your financial advisor illustrate the long-term benefits and weaknesses of incorporating such a strategy. When doing tax planning, the primary advantage we have over the IRS is that they are looking at a single calendar year while we are considering your entire lifetime. Have your CPA review the plan before implementing it as it’s always good to get a second opinion on these matters.

The distribution phase of retirement can be confusing as there are new rules and complicated strategies to be considered and assessed. The ideal goal is to balance current and future tax rates, while finding a good point between avoiding higher tax rates in the future, without unnecessarily increasing your taxes today.

Gardner Sherrill, CFP, MBA, is a certified financial planner with Sherrill Wealth Management. To learn more visit sherrillwealth.com, a Bradenton wealth management firm specialized on living in retirement. The opinions expressed in this material are not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial a registered investment advisor. Member FINRA/SIPC.

This story was originally published February 14, 2020 at 11:43 AM.