You need to save and invest as much as possible to pay for the retirement lifestyle you’ve envisioned. But your retirement income also depends, to a certain degree, on how your retirement funds are taxed. And that’s why you may be interested in tax diversification.
To understand the concept of tax diversification, you’ll need to be familiar with how two of the most important retirement-savings vehicles — an IRA and a 401(k) — are taxed. Essentially, these accounts can be classified as either “traditional” or “Roth.”
When you invest in a traditional IRA or 401(k), your contributions may be tax-deductible and your earnings can grow tax deferred. With a Roth IRA or 401(k), your contributions are not deductible, but your distributions can potentially be tax-free, provided you meet certain conditions. (Keep in mind, though, that to contribute to a Roth IRA, you can’t exceed designated income limits. Also, not all employers offer the Roth option for 401(k) plans.)
Of course, “tax free” sounds better than “tax deferred,” so you might think that a Roth option is always going to be preferable. But that’s not necessarily the case. If you think your tax bracket will be lower in retirement than when you were working, a traditional IRA or 401(k) might be a better choice, due to the cumulative tax deductions you took at a higher tax rate. But if your tax bracket will be the same, or higher, during retirement, then the value of tax-free distributions from a Roth IRA or 401(k) may outweigh the benefits of the tax deductions you’d get from a traditional IRA or 401(k).
So making the choice between “traditional” and “Roth” could be tricky. But here’s the good news: You don’t necessarily have to choose, at least not with your IRA. That’s because you may be able to contribute to both a traditional IRA and a Roth IRA, assuming you meet the Roth’s income guidelines. This allows you to benefit from both the tax deductions of the traditional IRA and the potential tax-free distributions of the Roth IRA.
And once you retire, this “tax diversification” can be especially valuable. Why? Because when you have money in different types of accounts, you gain flexibility in how you structure your withdrawals — and this flexibility can help you potentially increase the amount of your after-tax disposable income. If you have a variety of accounts, with different tax treatments, you could decide to first make your required withdrawals (from a traditional IRA and 401(k) or other employer-sponsored plan), followed, in order, by withdrawals from your taxable investment accounts, your tax-deferred accounts and, finally, your tax-free accounts. Keep in mind, though, that you may need to vary your actual sequence of withdrawals from year to year, depending on your tax situation. For example, it might make sense to change the order of withdrawals, or take withdrawals from multiple accounts, to help reduce taxes and avoid moving into a different tax bracket.
Clearly, tax diversification can be beneficial. So after consulting with your tax and financial advisors, consider ways of allocating your retirement plan contributions to provide the flexibility you need to maximize your income during your retirement years.