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Tax Diversification

TAX DIVERSIFICATION

 | July 31, 2019


One of the most common issues we see our clients facing in retirement is a higher tax bill than they expected.  The root cause of this problem usually lies in the fact that while they were working, they exclusively saved in pre-tax retirement accounts.  While the annual tax deduction for contributions to their pre-tax accounts was valuable, they never really understood the tax consequences it would have upon retiring. 

Why Tax Diversification?

Every dollar withdrawn from a pre-tax account in retirement is considered income taxable at ordinary income rates.

In addition, pre-tax accounts are subject to Required Minimum Distributions (RMD), meaning at age 70 ½ there is a requirement to withdraw a certain percentage of the account each year.  This gives you less control over your retirement income and sometimes results in you generating more income than you actually need. 

And as the cherry on top, your taxable income in retirement affects how much of your social security is taxable, how much you pay for your private insurance and Medicare premiums, and the rate your capital gains income is taxed at.

For these reasons, we’ve seen that having some tax diversification is just as important as being diversified in your investments.  By tax diversification we mean saving in a combination of pre-tax accounts, Roth accounts, and taxable accounts.

Case Study

Case in point, I recently met with some newer clients who are planning on retiring in about 3 years at age 62.  After they retire, they’ll have about 3 years to go before they are eligible for Medicare and therefore will have to get on a private health insurance plan in the meantime.

Because the vast majority of their savings are in pre-tax retirement accounts, almost all of their income in retirement will be taxable and therefore they wouldn’t qualify for the Premium Tax Credit, which helps offset the cost of private health insurance premiums.

Private health insurance is expensive, and we figured their estimated cost for a decent plan with a high deductible and 70% coinsurance would be about $2,000 per month.  That’s $72,000 worth of insurance premiums over a 3-year period!

Fortunately, with a few years to go before retirement there was still time to put together and execute a plan to diversify their tax savings, reduce their taxable income at the beginning of retirement (without affecting their lifestyle), and help them qualify for the Premium Tax Credit. 

The plan we put together utilizes a combination of Roth IRA contributions, Roth IRA conversions, and Mega-Backdoor Roth contributions (through his employer-sponsored plan) all in an effort to help them save enough money in Roth accounts to cover their expenses for the first 3 years in retirement. 

Since qualified withdrawals from Roth IRAs are considered tax-free income, they can qualify for the Premium Tax Credit and reduce their insurance premiums from an estimated $2,000 per month to an estimated $300 per month (or $72,000 over 3 years to just $10,800 over 3 years).

It’s important to keep in mind that over the next 3 years, by directing all of their savings towards Roth accounts they’ll miss out on tax deductions they could have received, but the savings from the insurance premiums more than offsets the additional tax (or in better words, the missed tax deductions for pre-tax retirement contributions).

Summary

Tax diversification, just like investment diversification is about one thing:  Increasing your risk-adjusted return. 

Just as we don’t know what the stock market will do in the future, we don’t know what our country’s tax or health insurance situation will look like over the next 5-10 years.  However, by helping our clients diversify their tax savings we can put them in the best situation possible to minimize their expenses and maximize their income in retirement.