Over the past few weeks we have talked about diversification within your portfolio. We use diversification to reduce potential risk. Another kind, tax diversification, occurs with the types of accounts in which you hold your assets and how withdrawals are taxed.
No matter how you make your money, Uncle Sam is waiting to take his share. You can structure withdrawals to be tax efficient and lower your tax burden. This is especially effective during retirement. For you to have income choices you must build these accounts prior to retirement, while you are young and in the "accumulation" phase of your life.
A well diversified portfolio will hold a mixture of assets - stocks, bonds, cash, real estate, precious metals, etc. Creating a tax-diverse portfolio means you hold assets in taxable, tax-deferred and tax-free accounts.
A trained advisor will scrutinize a retirement plan for tax efficiency. You want to minimize taxes by taking income from specific accounts.
Remember, money held in tax-deferred accounts (traditional IRA, 401k,etc.) is fully taxed as ordinary income on withdrawal paying both state and federal taxes.
If all your assets are tax-deferred, every withdrawal will count as income and could push you into a higher tax bracket. For example, say you need $60,000 a year for income, you must withdraw $72,000 to cover the 20% withholding. Add that to Social Security or pension income, you could bet bumped into the next tax bracket. But, if you could take $40,000 ($48,000 less 20%) from the IRA, $10,000 from your taxable account(paying some capital gains tax) and $10,000 from your Roth (tax-free), you maintain a lower taxable income.
Be $ Smart - build your savings in different types of accounts for tax efficiency.
Be sure to consult your tax advisor for specifics.
