Category: Everyday Finance

You’ve probably been told that the best way to save for retirement is with your employer’s 401(k), or similar retirement plan. The reasoning, you usually receive some sort of matching contribution from your employer and you receive an immediate “tax break” for the amount you contributed.

In general, this is good advice. However, putting all of your long-term savings into a tax-deferred account can be a serious mistake that doesn’t come to fruition until retirement.

That is because when the account is tapped for income, the withdrawals are subject to the highest possible tax rates, and IRS mandated distributions makes the problem even worse by causing taxation of income you may not even need until later in retirement.

The Time Bomb

Take for example a 70-year-old who has been living on $50,000 per year during their retirement. They have been receiving Social Security benefits of $24,000 per year so they were only taking around $26,000 per year from their investment portfolio to supplement.

They did a great job saving during their working years and have a balance of tax-deferred assets of around $1.5 million. Unfortunately for them, they turn 70 1/2 this year and the IRS has required they begin taking minimum distributions from the account. Based on the IRS’s Required Minimum Distribution worksheet, this person will need to take out nearly $55,000 from their assets this year alone! To compound the problem, the required minimum distribution gets larger the older you get. 

These excess distributions will cause their adjusted gross income to increase, which can lead to their Medicare premiums to rise and a larger portion of their Social Security benefits being taxed. Not to mention their overall tax liability increases!

So how do you mitigate this tax time bomb? The same way we manage most risks in finance…diversification.

Tax Diversification Basics

When you boil down the dozen or so ways you can own assets, there are only three basic ways your assets are treated for taxes: Taxable, Tax-Deferred, and Tax-Free.

“Taxable” accounts are simply individual, joint, and trust investment accounts in which you pay taxes on the income and capital gains generated each year. You receive preferential tax treatment on assets that you hold longer than one year in these types of accounts.

“Tax Deferred” accounts include traditional IRAs, 401(k) plans, SEP-IRAs, profit-sharing plans, 403(b) plans and similar accounts. Contributions to these accounts are often tax deductible, but not always. Withdrawals are taxed at your highest marginal income tax rates and the accounts are subject to mandatory distributions beginning at age 70 ½.

“Tax Free” accounts include Roth IRAs and Roth 401(k) plans, as well as Health Savings Accounts (HSA). Roth contributions are made after-tax, while HSA contributions are tax deductible. Withdrawals are tax free and are not subject to required distributions.

The ideal ratios are to have one-third of your assets in each of the three tax types as you enter retirement. But this is not easy to achieve because the default path for most investors is excess tax-deferred holdings due to:

1. The default election is for contributions to go into a tax-deferred 401(k) plan.
2. A tax-free Roth 401(k) plan might not be available. 
3. Employer contributions are made into a tax-deferred profit sharing plan.
4. If your income is too high, you can’t directly contribute to a tax-free Roth IRA.
5. Saving to a taxable account takes being proactive.

Extra attention has to be put into building tax-free and taxable accounts since the default accumulation path is having the majority of assets in tax-deferred accounts. 

Strategies To Achieve Diversification

The following strategies can be used to aid in tax diversification. Many of them can be used in conjunction with one another, but be aware that they become increasingly complex as you move through the list.

1. If you are eligible for a Health Savings Account (HSA), fund it to the maximum every year and invest it. Don’t make withdrawals for current health expenses. An HSA is the best tax account type in the U.S. (tax deductible, tax-deferred, and tax-free). You’ll have plenty of health expenses in retirement to begin using the account after years of tax-free accumulations.
2. If your 401(k) plan has a Roth option, use it. There are no income limits on a Roth 401(k), so even high-income earners can accumulate tax-free assets here.
3. Fund a Roth IRA each year if you are eligible.
4. Begin funding of a taxable individual, joint, or trust account.
5. If you have maxed out your 401(k) plan and are not eligible for a Roth IRA, contribute the maximum ($5,500/$6,500) to a non-deductible IRA. By carefully coordinating your IRA and 401(k) plan balances and eligibility requirements, you can convert these IRA contributions to a Roth IRA at a later date with minimal tax liability. This is often referred to as a “backdoor” Roth IRA.
6. If you have a particularly flexible 401(k) plan — or are a business owner/partner with the ability to control the features of your 401(k) plan — you can make after-tax non-Roth contributions to your plan, which can be subsequently converted to a Roth IRA with minimal tax liability. This would be the “mega backdoor” Roth IRA.
7. If you are nearing or entering retirement and feel behind on achieving tax diversification, there are some additional techniques you can use to enhance your tax diversification. This can be accomplished with partial Roth IRA conversions in concert with Social Security timing and other income and deduction timing strategies. If properly planned, your tax bracket can be pushed to very low levels for a single year, allowing a low-cost partial Roth conversion to occur. And it may be possible to repeat the technique every few years.

By implementing any number of the above strategies, most people can achieve reasonable tax diversification as they build wealth. Just make sure you are re-examining your current and projected tax diversification each year to make adjustments as needed.

The Benefits of Diversification

It is unlikely you will achieve perfect equalization between the three asset types, but aiming for tax diversification will help:

• minimize tax rates
• prevent the double taxation of Social Security benefits
• avoid higher Medicare premiums
• allow for tax-free payment of health care expenses and long-term care insurance premiums
• facilitate conversion of asset from tax-deferred to tax-free with nominal taxation
• pass wealth tax-free to heirs
• aximize tax deductions and standard exemptions and credits every year
• preserve ability to balance and time income sources
• add to your after-tax income and total lifetime wealth

You will find plenty of opinions claiming one asset type is better than another, but these are always based on certain assumptions that may not come true.

The bottom line is that no one can predict the future, especially decades in advance.  That’s why it’s wise to have assets spread across different asset types. 

The Tax Cut and Jobs Act (TCJA) introduced some significant changes to the rules concerning itemized deductions. In fact, many of the deductions on Schedule A — the itemized deductions — were repealed or modified in a way that limits their use.

Couple this with the (almost) doubling of the standard deduction and it’s not surprising that many taxpayers are simply taking the standard deduction.

With fewer taxpayers itemizing, certain deductible expenses — in particular, charitable contributions — are no longer providing any federal tax benefit.

Rather than giving up on charitable giving, taxpayers can use a strategy known as “bunching” to maintain some tax benefit for those gifts.

Bunching essentially means lumping multiple years’ worth of charitable contributions in a single year in order to take an itemized deduction in year one and the standard deduction in the following years.

How bunching produces Tax benefits

To help illustrate the tax benefit of bunching charitable gifts let’s look at an example assuming:

• A couple is married filing jointly, ages 60 & 58
• Total income reported from various sources is $160,000
• Line 7 of Schedule A (State and Local taxes) usually totals around $10,500
• Line 10 of Schedule A (home mortgage interest) is zero, they have no mortgage
• Line 14 of Schedule A (gifts to charity) is $10,000 per year
• Taxable income in 2019 is 135,600 (assuming they use the standard deduction of $24,400)
• Federal tax liability in 2019 is $19,764 based on the IRS tax chart
• This couple will be taking the standard deduction rather than itemizing, meaning the $10,000 annual gift to charity is no longer tax-deductible
• These underlying numbers will remain unchanged for each of the years

Running a series of multi-year tax projections produces the following tax outcomes.

In this case, lumping charitable contributions provides a total tax savings of $3,476 over three years, with the potential for additional tax savings through capital gains avoidance if appreciated stock is gifted.

bunching QUick guide

How do you know if the strategy makes sense? Hopefully, this decision tree will help you determine if you can benefit from bunching your charitable gifts.

Keep in mind that other tax strategies — like qualified charitable distributions and Roth conversions — can also be deployed when bunching charitable gifts that can produce additional tax savings!

Ultimately, if it looks like you would benefit from bunching your deductions, I suggest discussing it with your tax advisor. They’ll be able to help you navigate the timing of the gifts and the optimal amount, as well as the other strategies that are applicable to you.