What Is Tax Diversification?
Key Points – What Is Tax Diversification?
- Controlling Your Taxes at Different Stages of Your Life
- How Can You Spread Out Your Tax Diversification?
- Looking at the Three Tax Buckets
- Believe it or Not, Tax Planning Can Be Fun!
- 16 Minutes to Read | 25 Minutes to Watch
Paying Less in Taxes Sounds Intriguing, Doesn’t It?
Tax Diversification may not sound like a very exciting topic, but if done correctly over your lifetime, you can pay substantially less in taxes. Our Director of Tax and CPA, Corey Hulstein, joins Dean Barber on the Modern Wealth Management Educational Series to explain what tax diversification is and why it’s so important to achieve a successful retirement.
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A Tax Diversification Trio: You, a CFP® Professional, and a CPA
While Dean and Corey explain what tax diversification is in a nutshell in this educational series video, the ball is in your court after you finish watching it. Don’t worry, though, as the game of tax diversification isn’t a game of 1-on-1 basketball. If you follow the game plan that Dean and Corey laid out, you’ll be working alongside a CFP® Professional and CPA to make sure that you understand each step of the tax diversification process.
Along with working with professionals on your tax diversification, you can see how it works within our industry-leading financial planning tool. It can help paint a picture of how tax diversification is a crucial component of a comprehensive financial plan.
Controlling Taxes Over Your Lifetime
To break down some of the basics of tax diversification, Dean and Corey first want you to understand the goal of it. It’s all about controlling taxes over your lifetime. Obviously, controlling your taxes during the distribution phase of your life is important, but that’s not the only stage of your life that tax diversification comes into play. We’re going to review what tax buckets you should be saving in during different stages of your life to help highlight the importance of tax diversification.
“From a tax planning standpoint, a lot of what we look for is how that money is spread out,” Corey said. “In an ideal world, the Roth would be awesome, but for most people that’s not attainable. So, how can we spread this fairly evenly to have a nice distribution?”
The Three Tax Buckets
To answer Corey’s question, there are three different buckets that we look at for tax diversification. Those buckets are non-qualified (taxable) money, tax-deferred, and tax-exempt (tax-free). Let’s look at what each of those buckets entail before we break down when to apply each bucket to different stages of your life.
Your non-qualified money is money that has already been taxed. This includes savings accounts, brokerage accounts, and taxable money.
The next bucket is your tax-deferred bucket. It encompasses things like IRAs, pensions, 401(k)s and 403(b)s, and any money that has never been taxed. You’ve kicked that can down the road. Once you access that money, it’s taxable.
Another note here is that in most cases with tax-deferred, you get a tax deduction for putting the money in. There are some limits, but you get a tax deduction, and it grows without tax during the accumulation phase. It’s just 100% taxable once you begin taking the money out.
“It’s still a benefit on the front end. You deducted it from your taxes initially,” Corey said. “For a lot of older retirees, this was their only option for a lot of their working years. So, we do see a lot of money in this bucket come retirement age. That’s a big one that we’re planning for.”
The third and final bucket is your tax-exempt bucket. This is your Roth money. You’ve delayed the benefit of that and paid taxes on the front end. But once you access that money, it’s all tax-free.
So, we look at tax diversification, we’re striving to have an even spread between those three buckets. That’s going to create a lot of flexibility when it comes to tax planning and distribution planning.
A Quick Example with $1 Million
Before we review tax diversification at various life stages, there’s a quick example from Dean that we want to share. In that example, someone has saved $1 million. Of that $1 million, one-third of it’s in a Roth, one-third of it’s in a traditional IRA or tax-deferred, and one-third of it’s in a taxable account. This person also has Social Security on top of that $1 million.
“The one thing that our industry has trained advisors to tell their clients is to not take any of that tax-deferred money out until you absolutely need to. But in a scenario like this, it might be a good idea to start spending some of that money down from the traditional IRA, some from the Roth, and maybe some from the taxable account. The only part that’s going to be taxable at 100% is the traditional IRA. They can get more income with less total tax.”
Income and Cash Flow Can Change Drastically in the Distribution Phase
Corey just had a similar situation like that with a client. When you get to distribution phase of life, your income and your cashflow are very different from a tax perspective. Corey explained to the client that when you have non-qualified money, you have got cashflow to live on throughout the year. But from a tax perspective, you can just pick and choose wherever you want to land.
“Like Dean was saying, we can just take money out of that tax-deferred bucket via Roth conversions. Or if it’s just simply distributing cash, either way is going to be fine,” Corey said. “But the way I phrased it to the people the other day was, ‘We’re going to meet every year and pick what you want your taxable income to be. It’s just a different way of looking at taxes that they’ve always had in their life.”
Tax-Gain and Tax-Loss Harvesting
When you’re meeting with Corey or another CPA to do that, one thing you’ll look at is tax-gain and tax-loss harvesting. You may have a year where you’ve experienced excess capital gains. So, let’s spend those capital gains. That kicks the tax deferred bucket down the road a little bit.
And sometimes, you need to change throughout the year too. It might not be as simple as deciding in October of what buckets you’re going to spend out of for the next year. You might need to make an adjustment in February, March, or April.
“We can always lay out a one, two, three, or even a four-year plan. But who knows what the market is going to dictate,” Corey said. “Obviously, we’ll need to pivot depending on what happens throughout the year. That’s why we’re constantly looking at these things. Maybe you want to grab losses to pivot against a bunch of gains. Those are all going to be different strategies that we’re going to look at in that distribution phase.”
Having the CPA and CFP® Professional on the Same Page
This is one of the critical factors of having a CPA working alongside a CFP® Professional like we explained from the get-go. They both need to be on the same page with what the client is trying to do. The CFP® Professional is going to be focused on controlling risk and getting the income the client needs. Meanwhile, the CPA has the same focus of getting the income the client needs, but in the most tax-efficient manner possible.
“To do that, you really do have to look forward,” Dean said. “I always say that you shouldn’t put your money into any type of an account until you know the rules for getting the money out and when you’re going to take it out. You need to have that forward-looking projection. You’re looking out 10, 15, 20 years sometimes.”
Building Tax Diversification as a Young Adult
Now that we’ve explained what tax diversification is, let’s look at how you go about building it. We’re going to start this tax diversification journey once you graduate college and/or get your first job. Most companies now offer a 401(k) and oftentimes offer a Roth 401(k). So, you could do traditional tax deductible 401(k) contributions or after-tax contributions to the Roth portion of the 401(k).
Roth or Traditional?
Keep in mind that this is probably when you’ll be making the least that you’re ever going to make in your life if you do the right career path. So, which one are you going to pick? Traditional or Roth? Let’s see what Corey thinks.
“A big component in this situation is that our tax rates are likely lower today than what they’ll be in the future. The other thing we’re going to look at is how much growth potential there is on the account,” Corey said. “During your younger years, At this stage, there are a lot of years for the account to grow. So, let’s throw it in the Roth. We’re going to delay benefit today. But all that gain that we’re going to see over the next 30-40 years is going to be tax-free.”
The tax-free aspect is a beautiful thing. You take it out in retirement and there are no taxes due. You get years and years of compounding inside that Roth IRA or that Roth 401(k), and then you can take it out tax-free.
Rules for Company Matches
Now, let’s assume that that individual has a company match in the 401(k). Under the current laws, the company match must go into the traditional side of the 401(k).
“One thing that I always encourage younger people to do is to max out the employer portion as well. If your employer matches dollar for dollar on the first 3% to 4%, make sure you contribute at least 3% to 4%,” Corey said. “Then, I recommend the full Roth. Inherently what happens is now you’ve got 50% of your account in Roth and 50% in traditional. You’re getting both sides of the coin just from that employer match standpoint.”
What About the Non-Qualified (Taxable) Bucket?
By doing that, you’re beginning to build tax diversification. But there’s more to the tax diversification picture. Let’s now look at the non-qualified (taxable) bucket with investing money in brokerage accounts or buying ETFs, mutual funds, stocks, etc. Is it a good idea for people to start getting a good amount of money saved in there and not just put everything into a 401(k)?
“It’s always good to start early,” Corey said. “It comes from your disposable income. It doesn’t have to be that we’re building this massive savings or brokerage account. You could be getting equity in your home. That’s going to be accessible later as well. Those are all different avenues to get non-qualified money. It’s coming from disposable income, living below your means, things like that. It’s always good to start that portion early as well.”
Beware of the Tax-Deferred Snowball Effect
Dean has realized that more and more people seem to be understanding tax diversification a little bit better in recent years. But all it takes is for one person to not understand to remind him that he needs to continue to educate people about it.
“Let’s say that someone has saved around $2 million and they’re getting ready to retire. They have $20,000 in their savings account and $2 million in their tax-deferred 401(k),” Dean said. “Well, they’ve really painted themselves into a corner to where every dollar that they take out is not only going to be taxable, but it’s potentially going to cause their Medicare premiums to be higher. It could also cause more of their Social Security to become taxable. It becomes this snowball effect of having too much in just tax-deferred.”
While having $2 million saved in a tax-deferred 401(k) is a good problem to have, it is a problem. Let’s start planning on that early because there’s still a window of opportunity. We can still try to shift some of that money over to a Roth bucket or take some of it at a reasonable tax rate and get it into non-qualified money as well.
We can get you out of that corner in some fashion, but it’s going to take time. It can’t be done in one or two years.
Tax Diversification During Your Working Years
Now, let’s look at tax diversification for someone who is in their mid-30s. Their careers are advancing. They might be married and/or have children. Hopefully, they have a house by now and have a decent amount built up in their 401(k). Ideally, they’ll have some money in a Roth 401(k).
If you decide to have children, suddenly you need to start thinking about funding a college education(s), What is all that going to look like? Things change at this point in life, but tax diversification remains important. Where are you going to put your money? What’s your income now? And what is your tax rate now compared to what it will be in the future?
“I think that’s really the point where people can start to think about when they would like to not need to work anymore?” Dean said. “How much will they need to retire today and have the lifestyle they want to live on? You can start to build that plan out into the future. You can make very good decisions on where that money gets saved.”
Liquidity Is Important Too
When you’re looking at tax diversification, liquidity becomes much more of an issue. If you have money in Roth and traditional, you want to have that tax-deferred bucket to get money out for things like college, emergency visits with young kids, and things of that nature. No matter the issue, you need to think about liquidity. Money in that non-qualified bucket becomes more important. And in your peak-earning years, you’re getting into those higher tax brackets.
“Maybe it makes sense to have a little bit of a shift in focus. Let’s try to get more money in tax-deferred,” Corey said. “But this is a little bit of a tougher decision. There are also a lot of years of growth as well. That’s something that you probably want to meet with your advisor on. Figure out what the best scenario is for you in that situation.”
This Is a Crucial Time for Planning
To Corey’s point of meeting with an advisor, we want to remind you of some of the capabilities that our financial planning tool has. When using our tool, you can see what the future tax impact will look like in retirement based on current tax laws when we’re looking at adding to a Roth 401(k) versus traditional 401(k). Which option gives you the best probability of success?
This is also a big reason that Corey loves the transparency of tax planning.
“In traditional public accounting, I don’t have that software. That’s where I rely on CFP® Professionals to show me what an account is going to grow to,” Corey said. “What is the situation going to look like in 10-20 years on this thing when we start accessing this money. It’s really going to put dollars and cents to the numbers that we’re using today.”
Tax Planning Is Complex, Clarity Is Important
There’s no question that tax planning is complicated, but it’s so important. The clarity it can give you is one of the main reasons why. You need to know what bucket you’re putting your money into and be confident about it.
Tax Diversification as You Approach Retirement
The next life stage will look at tax diversification for is for 50-to 55-year-olds. Usually at this point in your life, your kids are grown or they’re maturing. They might be in college by now or even graduated from college. You’re getting to where you’re an empty nester.
Roth, RMDs, and Decisions
Also, you’ve got more disposable income than you’ve ever had. You’re probably in your peak earning years and paying more than you ever have. This is where you really have to step 10 to 15 years into the future, especially looking at the Required Minimum Distributions on that tax-deferred bucket.
“Does it make sense to stop doing the Roth now because you can get a better tax break today? I may be in a higher bracket today, and I’ve already got all this money built up in Roth,” Dean said. “Now, I can start to combine and blend those together as I start spending money in retirement. You can even do some Roth conversions after you retire and get the money out of the traditional over to the Roth at a lower tax bracket than we’re in today. That’s where I think it really gets fun.”
Wait…Tax Planning Can Be Fun?
This kind of goes back to what we were discussing earlier. We’re going to pick a number and we can’t do that obviously when you’re working. All that income is taxable today, but that’s where you project out 10 to 15 years and you’re having to turn off that income stream of wages. What does your income look like from a tax standpoint?
“If you’ve got that non-qualified bucket sitting there, we can pretty much pick and choose our spots,” Corey said. “Let’s pivot over from the Roth. Let’s put it into the tax-deferred bucket while we’re in those high tax brackets. We know that we’re going to have a period of years where we’re in the low brackets. So, let’s artificially inflate your income in those years. Again, you’re picking and choosing your spots. Paying lower taxes over the course of your lifetime is the goal.”
One of Dean’s Favorite Deanisms
Whether you’ve known Dean for a few months or several years, you’ve probably noticed that he has a few favorite quotes or sayings. One of his most famous ones involves taxes.
“I’ve always said that taxes are going to be a part of your life as long as you live in America and you either have money or make money. They’re going to be a part of your life,” Dean said. “So when we talk about tax diversification and tax planning, those really come hand in hand with each other. The idea is to figure out how I’m going to pay the least amount of taxes over my lifetime, not in a given year.”
Leaving Money to the Next Generations Involves Tax Diversification
And it’s not even just over your lifetime. What about your kids’ lifetimes? Many of our clients are passionate about leaving money to the next generation. So, where is your money going to end up after you pass?
As you think about that question, you need to be aware of the role that the SECURE Act plays in this situation. The SECURE Act eliminated the Stretch IRA. That means that when a traditional IRA is passed down to the next generation, the money needs to be out within 10 years.
The SECURE Act Is Another Reason Why You Need to Start Planning Sooner Rather Than Later
Most people that are inheriting those IRAs are in their 50s and early 60s, so they’re in their peak earning years. They could be forced out on them at super high tax rates.
“The SECURE Act was probably one of the worst acts that I’ve ever seen. Yet it got huge bipartisan support,” Dean said. “The reason that it got huge bipartisan support was because they knew it was going to increase the revenues to the treasury without having to increase taxes.”
Hopefully this helps to explain why it’s critical to do the planning on the front end. If you don’t, your kids will be the ones getting the tax bill.
It might not be the worst problem in the world to have because they got cash as well. But how much money could we have saved in taxes over the course of both lifetimes?
Tax Diversification When You’re Retired
We just started to dip into a few aspects of tax diversification in retirement, but there are a couple of big points we want to make here. Let’s first talk about the impact of the taxation of Social Security when you turn that Social Security check on. Social Security is taxed differently than the taxable account, tax-deferred account, and Roth account.
The Tricky Aspect of When to Claim Social Security
Social Security income is unique and hard to explain. It gets tossed into this formula, and how much your other taxable income is determines how much of your Social Security will be taxable.
“If we artificially inflate your income, your Social Security suddenly becomes more taxable as well. That’s a tough decision to make for a lot of people,” Corey said. “You really need to dial in with your advisor and CPA on when you want to start claiming Social Security. It’s going to affect your long-term planning as far as how much money you can move out of that tax-deferred bucket.”
There’s a Lot that Goes into Your Decision to Claim Social Security
There are a lot of Social Security claiming strategies. For the average couple that’s 62 years old, there could be 600 to 700 iterations of how they claim their Social Security. There’s Social Security planning software that can tell you which one of those iterations is going to give you the most income from Social Security.
But you can’t stop there because of the impact of taxes on the Social Security and how it plays with all the other sources of income that you have. The best decision on how to get the most out of Social Security might penalize you on the tax side. Suddenly, that’s not the best decision anymore.
“It’s not something you can throw into computer and just hope it’s right. The numbers can shake out correctly on the computer, but it can throw off a lot of things on the planning side,” Corey said. “Just to make sure, talk about it with your advisor so you’re on the same page. The taxes long-term might make it worth holding off on claiming Social Security.”
What Is Provisional Income?
What Corey is starting to dive into here is called provisional income. Provisional income looks at all your cash flow, your income sources from a tax perspective. This is going to be your tax-deferred money. It’s going to take half of your Social Security benefit and add that to the formula for provisional income as well. Like we said, it’s a unique formula specifically tied to Social Security. That’s really the only situation where provisional income is being used.
“What’s cool is that when we’re working together with our financial planning tool, we can say, ‘OK, if you turn Social Security on at 70 and take some income from the Roth, some from the traditional, some from the account that’s already been taxed, here’s the effect of taxation on your Social Security,’” Dean said. “Well, if we change those distributions, how does that impact the taxability of your Social Security? Because I’ve seen people that could have spendable income in the $80,000 to $100,000 range, and none of their Social Security is taxable because it’s coming from the right bucket.”
That’s part of why you need to do the planning on the front end. If you hit RMD age and didn’t do that planning, you’re almost too late from the Social Security standpoint.
The Ticking Tax Time Bomb and How to Diffuse It
We just touched briefly on RMDs, but before we wrap up, we want to talk a little bit more of them and reference our good friend Ed Slott. Several years ago, he wrote a book called, The Tax Savings Time Bomb and How to Diffuse It. The concept was all about looking at what those RMDs are going to look like by the time you’re in your 50s.
“Don’t wait until you’re really close to having to take these RMDs. Start looking at what that’s going to look like early on,” Dean said. “And once again, our financial planning tool can take people through this. If you don’t take distributions out of your traditional IRA and just let this thing grow and assume it grows at 6% or 7%, here’s what your value’s going to be, here’s how much your RMDs going to be, and here’s what your tax bill is going to be.”
Why Tax Diversification Matters
It could also cause Medicare premiums to be higher. It could cause up to 85% of your Social Security to become taxable. Capital gains that were tax-free could become taxable. Qualified dividends that were tax free could also become taxable. So, you need to understand all those different components.
“That’s why it’s critical that you don’t just say, “Let’s just save as much as we can,’” Dean said. “Save it into the right bucket. Get the diversification that you need so that you can control your taxes during that second half of your life, that distribution phase. People have more control over their taxes in that distribution phase of their life than any other time in their life.”
Once again, you can pick and choose your spots at that point as long as you’re working with a professional. While Corey, Dean, and the rest of our team believe it’s important to focus on tax diversification sooner rather than later, it’s not too late to start in your 50s and early 60s. There are still strategies we can implement. But it’s important to get with an advisor sooner rather than later to maximize your situation as much as possible. It’s never really “too late,” but let’s find any opportunity we can in the current situation.
Do You Have Questions About Tax Diversification?
We welcome the opportunity to assist you with all things tax diversification as it relates to your unique situation. Take a look at how tax diversification can make a huge difference by using our financial planning tool. Just click the “Start Planning” button below to access the same tool that our CERTIFIED FINANCIAL PLANNER™ Professionals use from the comfort of your own home.
As you’re navigating our financial planning tool, please know that it’s intended for professional use. If you have questions that arise as you’re using it—whether they’re about tax diversification or whatever it may be—you can schedule a 20-minute “ask anything” session or a complimentary consultation with one of our CERTIFIED FINANCIAL PLANNER™ Professionals to ask those questions. We will screen share with you while using the tool so that you have clarity about your financial life.
We hope you now have a better understanding about tax diversification and the difference it can make for you. It’s not too early or too late to see how tax diversification can impact you.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.