How to Reduce Risk With Tax Diversification

Tax day has come and gone and taxpayers can go back to more enjoyable pastimes for another 10 months. However, it would behoove those in the higher brackets to take time to consider whether they are adequately diversified from a tax standpoint.

Just as there are benefits to investment diversification, there are benefits to tax diversification. Both seek to reduce different types of risk. From a tax standpoint, the risk we are trying to mitigate is that you may pay more tax—either because of poor timing, changes in tax laws/rules, or a change in circumstances.

Tax Treatment of Different Income Categories

To understand tax diversification you must start with an understanding of the broad categories of income in terms of tax treatment as it relates to retirement:

  • Tax-free: Roth individual retirement accounts, municipal bonds, or return of basis
  • Fully taxable: Withdrawals from traditional IRAs, 401(k) and 403(b) accounts (where pre-tax contributions have been made)
  • Fully taxable and earned income: Your salary, self-employed income
  • Partially taxable: Social Security, non-qualified lifetime annuity payments
  • Tax-favored: Long-term capital gains, qualified dividends
  • Other Income: Rental income, pension income, non-lifetime annuity income

You can think of these as different ‘buckets’ of money, and the idea is that you’d like to have the ability to choose when and how to recognize income from each so as to optimize your tax situation.

For most of your life, you don’t have the luxury of managing your income to reduce tax. You work, you are paid, and you pay taxes. But in retirement, you need to adjust your thinking. Since pensions have been replaced by withdrawals from 401(k)s/403(b)s and IRAs, you are now in position to manage the income you recognize. Here’s where tax planning has real advantages.

Our current tax system involves a tiered, progressive structure of tax brackets and a certain allowance for deductions. These deductions will vary depending on the individual circumstances, but at a minimum involve the standard deduction ($/pp) and exemption ($/pp).  This means that the first $ of income is free of tax. If you itemize deductions, this initial amount of tax free income may be higher due to mortgage interest, charity or tax deductions.

The Best Tax Strategy

Once you exceed the deductible amount, you are in the lowest 10% bracket up to $18,650, then you are in the 15% bracket up to $75,900. The best strategy is to “fill up” the first two brackets with income. This income can be from earnings, Social Security, ordinary dividends, pension or rental income, for example. Here’s where it gets interesting. All of those income streams you don’t control the timing completely. But your retirement withdrawal you can control (unless you are over 70 ½ when you have required distributions). So if you have some “room” left in the 15% bracket, you should consider taking more out.

From a practical standpoint, I find it best to do this kind of tax planning in November or December, when you have a clear picture of your income for the year. One easy place to start is to use last year’s tax return as a starting point, but be cognizant of new income items and changes. Once you have “filled up” the first two brackets, look to other sources of income that are less taxing—like Roth IRAs, sales of securities with little gain, or long-term capital gains.

One complicating factor to this tax planning exercise, is the interplay of Social Security taxation, Medicare premium payments, Obamacare credits and the taxation of long-term capital gains with the recognition of income. Each one of these are impacted by your income level, so be careful to factor these in.

By having more “buckets” of income to draw from, you will have flexibility in planning your income for the year and optimizing the tax you pay.

Unlike investment diversification which can be achieved quickly through re-allocation, tax diversification takes years to develop. It is something that you must focus on in your 20s, 30s and 40s, because of the rules involved in contributing to tax advantaged accounts. It may not seem important today, but the tax diversification you are building now, will benefit you for many years in the future.

Robin Sherwood, CFP®

With over twenty years of experience, Robin assists clients in maximizing their financial well-being. She counsels clients in the areas of retirement, taxes, investments and estate planning.

Robin is a CERTIFIED FINANCIAL PLANNER™ practitioner and a registered member of NAPFA. She has an MBA in Finance from the Wharton School at the University of Pennsylvania, and a BA from Colby College.