Have you ever considered the possibility that you may earn a higher income after you retire than you have now? It sounds crazy, I know, but it’s not as uncommon as you might think. That's where tax diversification comes in.
People living longer than they have in the past are also working longer than ever. Many have a substantial income from retirement investment income, Social Security, and income from a job or business.
If that is the case for you – and it is not at all unlikely – you’ll have to add tax diversification to your retirement portfolio. And you’ll have to do it now because such a strategy will require time and steady investment.
What Is Tax Diversification?
Tax diversification is one of the most underrated financial planning concepts. It's a strategy that involves putting your investment funds into multiple types of holding based on how and when they are taxed.
Tax diversification for retirement can include one or more of the following assets: Roth IRA, non-tax-sheltered investments, and real estate. Let's examine why these assets could be critical to your investment strategy.
You don’t get a tax deduction for making a Roth IRA contribution as you would if it were a traditional IRA. But that also means the contributions will not be taxable when withdrawn. In addition, if you do not begin withdrawing funds until after you turn 59 ½ – and if you have had your Roth IRA for at least five years – no income taxes are levied on your investment earnings.
Other retirement plans you have – 401(k)s, 403(b)s, 457s, and traditional IRAs – are all tax-deferred. That means that the tax deduction you are getting now for the contributions and the deferral on the investment accumulation will be taxable upon withdrawal. That will put you in a higher tax bracket. But, a Roth IRA can offer relief and allow you to take tax-free withdrawals.
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Non-Tax Sheltered Investments
We know that money grows much more quickly in a tax-sheltered investment vehicle, like a retirement plan. But since non-sheltered plans are built and accumulate earnings on after-tax money, there is no deferred tax liability. You can withdraw money from these accounts without concern about increasing your taxes.
For this reason, you should never overlook non-tax-sheltered investments as a part of your tax diversification retirement plan. They provide you with a tax-free source of funds that will help you to minimize the amount of taxable money you withdraw from your retirement plans.
They will also provide you with a ready source of cash in the event of an emergency. This emergency might otherwise significantly increase your tax burden if you have to access your retirement accounts for the money.
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Real estate is another excellent way to accumulate tax-free capital for retirement. However, this is more true for your primary residence than investment property.
On your primary residence, you will have a one-time exemption on the gain on the home's sale for tax purposes. If you are single, you can exclude up to $250,000 of the gain from your taxable income. For married couples, the exemption is up to $500,000.
This is to say that you can sell your home and raise that much capital – plus your original investment – and have that money available for retirement without consideration of income taxes.
The same is not true with an investment property. There is no one-time exemption for the gain on the sale. But perhaps more significantly, your tax liability on an investment property could rise over time. This is because it is common for investors to depreciate the value of their investment property over the number of years they own it.
This reduces the property's cost basis, increasing the profit on sale – all of which will be taxable as a long-term capital gain. It is possible that you can incur an income tax liability even if the value of the property does not increase or even if it declines. This will happen anytime the property's depreciated value falls below the acquisition cost.
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Paying Off Your Debt
While this is not technically an investment strategy, it still impacts your income tax liability. If you pay off all your debts before retirement, you’ll need less income. That will mean you will need less to draw money out of your retirement accounts, reducing your income tax liability.
The best part of the strategy is that it is probably something you plan to do as part of your retirement plan. But perhaps this gives you a little greater incentive to do so.
So Why Should You Add Tax Diversification to Your Retirement Portfolio?
Tax diversification is one of the most underrated financial planning concepts. The ideal mix should be based on your individual retirement goals. For the best results, you should consult a qualified financial advisor to discuss options for diversification.