Tax Diversification: How to Retain More Money in Retirement

No one likes paying taxes, especially after retirement, when you are not earning a paycheck. It is, however, possible to reduce your payment to Uncle Sam, and the following actions might help reduce your future tax burden.

A well-thought-out strategy will help you be more prepared for the obstacles you may face as you move toward and through retirement, despite your inability to control them. This is especially true regarding market volatility and taxation, two of the greatest threats to a confident and prosperous financial future.

You’ve likely heard a lot about volatility recently as the market responds to the most recent news regarding interest rates and the potential for an economic downturn. If these fluctuations make you anxious, it may indicate that your diversified portfolio’s asset allocation does not match your risk tolerance. Perhaps it’s time to speak with a financial advisor.

While you’re at it, you should initiate a strategy to reduce taxes, which currently receive less attention in the headlines but might pose an even greater danger to your retirement income. Given the current tax climate and the projected tax environment in the near future, you should diversify your portfolio to avoid possessing too many assets that are taxed simultaneously.

How to split your assets

To do this, it is useful to imagine three buckets containing your investments.

The “taxed-now” category includes earnings, wages, non-qualified brokerage accounts, checking and savings accounts, assets that yield interest and dividends, and capital gains.

The “taxed-later” bucket consists of 401(k)s, conventional IRAs, and other tax-deferred retirement accounts, as well as real estate, physical assets, and collectibles.

The “rarely or never taxed” bucket consists of Roth IRAs, Roth 401(k)s, health savings accounts (HSAs), municipal bonds, and some forms of life insurance.

If you’re like most savers, you presumably have most or all of your investments in the taxed-later bucket, which might be problematic. This is why: These accounts serve you well by reducing your annual tax burden while working, but when you begin withdrawing money from them in retirement, it will be taxed as regular income. Contributing to a retirement account is simple. Withdrawing funds from a retirement account can be difficult and costly.

Several issues with the “taxed later” bucket

These tax-deferred accounts include an obligation that is frequently forgotten. Here’s an appropriate perspective:

If you own a home worth $500,000 but still owe $200,000 on the mortgage, you are aware that you do not possess a $500,000 asset. You possess $300,000 in assets. Similarly, the money within is not entirely yours if you hold a $500,000 401(k). The IRS, awaiting payment for years, is owed a large piece of it. The taxed-later bucket is a retirement plan that defers taxes.

The IRS will also want it cut as soon as you begin receiving your portion of the funds. Even if you elect not to withdraw the money because you don’t need it — perhaps your Social Security income and pension are sufficient – the IRS will mandate you to take required minimum distributions (RMDs) at age 72.

These distributions may place you in a higher tax bracket and require you to pay taxes on a larger proportion of your Social Security payments. You may even have to pay a higher premium for Medicare Parts B and D. Add to that the possibility that if you withdraw funds from your assets during a market downturn, whether for income or RMDs, you will have significantly less money to live on in your later years. This might have disastrous consequences for your way of life.

Would you borrow money from a bank if the interest rate charged throughout the loan term was not disclosed beforehand? Has the IRS disclosed the maximum lifetime tax liability it can levy against you? This is the difficulty posed by the taxed-later bucket!

Is it time to convert to a Roth IRA?

Making adjustments that can improve your retirement security and save money is never too late. This is the right time to initiate these reforms. Thanks to measures that have lowered tax rates until the end of 2025, taxes are on sale for the next three years! You can eliminate your current Uncle Sam obligation by converting the funds in your tax-deferred retirement accounts to an after-tax Roth IRA or similar plan over the following several years and paying taxes on the funds.

After the existing tax cuts expire, most economists believe that tax rates will increase — and significantly higher rates are not unprecedented. Those with taxable incomes over $539,900 (individuals) or $647,850 (married filing jointly) are subject to a 37% tax rate (married filing jointly). The current tax rates for the two middle tax categories are 22% and 24%. Historically, rates were far higher. In 1944, the highest federal rate was 94%. And throughout the 1950s, 1960s, and 1970s, the top rate never dropped below 70%.

This is a chance to transform your assets into tax-efficient investments by diversifying your portfolio. In a world full of what-ifs and bad news, it is a good move you can make to safeguard your retirement goal.